Chapter 13

1. Chapter 13 Current Liabilities and Contingencies

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

3. What is a Current Liability? LIABILITIES Current Liabilities Long-term Liabilities Obligations payable within one year or one operating cycle, whichever is longer. Expected to be satisfied with current assets or by the creation of other current liabilities.

4. Accounts payable Cash dividends payable Accrued expenses Current Liabilities Taxes payable Unearned revenues Short-term notes payable Current Liabilities

5. 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. Credit lines Prearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork. Open Accounts and Notes

6. Notes Payable 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.

7. Interest-bearing Notes On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 6 months and has a stated interest rate of 9%. Record the journal entry. September 1: Cash .................................................... 80,000 Notes payable ....................... 80,000 To record short-term note payable to Cooke Bank. How much interest is owed (accrued) to Cooke Bank at year-end, on December 31? $80,000 × 9% × 4/12 = $2,400

8. Assume Eagle Boats’ year-end is December 31. Record the necessary adjustment at year-end. Interest-bearing Notes December 31: Interest expense ................................... 2,400 Interest payable ....................... 2,400 To accrue interest on note due to Cooke Bank. Record the journal entry for the loan repayment when the note matures on February 28. February 28: Interest payable ................................... 2,400 Interest expense ................................... 1,200 Note payable ……………………………. 80,000 Cash …………………………… 83,600 To pay off note and interest.

9. Notes without a stated interest rate carry an implicit, or effective rate. The face of the note includes the amount borrowed and the interest. Noninterest-bearing Notes

10. On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount of $10,600 and a discount rate of 5.66% in exchange for equipment. How much interest will Batter-Up pay on the note?What is the effective interest rate? Noninterest-bearing Notes The Discounted value of the note is: 10,600 * ( 1 – 5.66%) = 10,000 (rounded) Interest = Face Amount - Amount Borrowed = $10,600 - $10,000 = $600

11. Noninterest-bearing Notes On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount of $10,600 and a discount rate of 5.66% in exchange for equipment. What is the effective interest rate on the note?

12. Commercial Paper Commercial paper is a term used for unsecured notes issued in minimum denominations of $25,000 with maturities ranging from 30 days to 270 days. -Issued directly to the lender -Backed by a line of credit -Large, highly rated firms -Lower rate than through a bank loan -Interest often discounted at the issuance of the note Recorded in the same manner as notes payable.

13. 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.

14. Vacations,Sick Days, and Other Paid Future Absences • An employer should accrue an expense and the related liability for employees’ compensation for future absences (such as vacation pay) if the obligation meets all four of these conditions: • The obligation is for services already performed. • The paid absence can be taken in a later year—the benefit vestsor the benefit can be accumulated over time. • Payment is probable. • The amount can be reasonably estimated.

15. Compensated Absences (a) Vested rights: An obligation to pay employee exists even if employment is terminated. (b) Accumulated rights: Can be carried forward to future periods if not used in the period earned.

16. Vacation Pay: ILLUSTRATION 13-2 (Page 699) When the necessary conditions are met, compensated future absences (vacation pay) are accrued in the year the compensation is earned. Example: Davidson-Getty Chemicals has 8,000 employees. -Each employee earns two weeks of paid vacation per year; -Vacation time not taken in the year earned can be carried over to subsequent years. During 2011, 2,500 employees took both weeks' vacation, but at the end of the year, 5,500employees had vacation time carryovers as follows:

17. Vacation Pay: ILLUSTRATION 13-2 (Page 699) During 2011, compensation averaged $600 a week per employee. Journal Entries:1. When Vacations Were Taken in 2011; 2. Accrual of future vacation (compensated absence) expenses on December 31, 2011.

18. Vacation Pay: ILLUSTRATION 13-2 (Page 699) The liability for paid absences usually is accrued at the existing wage rate (2011) rather than at a rate estimated to be in effect when absences occur. So, if wage rates have risen, the difference between the accrual and the amount paid increases compensation expense that year (2012). Actually, FASB ASC 710–10–25 (Compensation–General–Overall–Recognition) is silent on how the liability should be measured. In practice, most companies accrue at the current rate (2011) because it avoids estimates and usually produces a lower expense and liability. Then, later, they re-measure periodically at updated rates (2012).

19. Vacation Pay: ILLUSTRATION 13-2 (Page 699) In this particular situation vacation time is carried over from 2011 at $5,400,000 and is taken in 2012 when the actual rate per week, per employee is at $633.33. Therefore, when Year 2011 Vacations Are Taken in 2012 the amount paid to employees is: $5,700,000 = 9000 * $633.33 (rounded) Liability—compensated future absences …. 5,400,000 Salaries and wages expense ....................... 300,000 Cash (or salaries and wages payable) ............... 5,700,000

20. Calculating Vacation Pay Accruals Illustration: Assume that Nichols Co. has 50 employees during 2005. Each employee earns 10 days of vacation pay per year. Assume that each employee’s salary rate during 2005 is $100 per dayand 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 2005. When they are paid their vacation pay, record this entry: Vacation Payable (10 x 10 x $100) 10,000 Cash 10,000

21. Calculating Vacation Pay Accruals 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 *$5 = (105 – 100)

22. 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.

23. Refundable deposits Advances from customers Gift cards Collections for third parties Liabilities from Advance Collections

24. Advances from customers 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 20 Unearned subscriptions revenue 20 When Product is Delivered Unearned subscriptions revenue 5 Subscriptions revenue 5

25. Gift Cards During their December 2010 Christmas promotion, MegloMart sold 20,000 gift cards at $25 each. All gift card sales were for cash. On December 31, 2010, only 1,000 gift cards had been redeemed. Unused gift cards expire on December 31, 2011, if not used to purchase MegloMart merchandise. Prepare the journal entries on December 31, 2010 to record the December 2010 sale and redemption of gift cards. December 31, 2010: Cash (20,000 × $25) ................................... 500,000 Unearned revenue …....................... 500,000 To record cash received from gift card sales. December 31, 2010: Unearned revenue (1,000 × $25) ............... 25,000 Sales revenue …............................. 25,000 To record revenue from gift card redemptions.

26. Gift Cards By December 31, 2011, 18,500 additional gift cards had been redeemed. Prepare the journal entry on December 31 to record the 2011 redemptions. December 31, 2011: Unearned revenue (18,500 × $25) …................. 462,500 Sales revenue (18,500 × $25) …......... 462,500 To record revenue from gift card redemptions. On December 31, 2011, the 500 remaining cards had not been redeemed. Prepare the journal entry on December 31 to record the gift card expirations. December 31, 2011: Unearned revenue (500 × $25) …..................... 12,500Gift card breakage EXPIRATION revenue …… 12,500 To record revenue from gift card expirations.

27. A Closer Look at the Current andNoncurrent Classification 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). 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.

28. A company may reclassify a short-term liability as long-term if two conditions are met: • 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 • It has the intent to refinance on a long-term basis. • It has demonstrated the ability to refinance. and

29. Short-Term Obligations Expected to be Refinanced The concept of substance over form. Consider a 20-year bond. Normally it as a current liability on the balance sheet prepared during its 20th year. But suppose a second 20-year bond is issued to refund (REFINANCE) the first issue when it matures. Do we have a long-term liability for 19 years, then a current liability in year 20, and then another long-term liability in years 21 and beyond? Or, Do we have a single 40-year, long-term liability? The substance over form of the events obviously supports a single, continuing, noncurrent obligation.

30. Short-Term Obligations Expected to be Refinanced on a long-term basis ILLUSTRATION 13-5 (Page 703) Brahm Bros. Ice Cream had $12 million of notes that mature in May 2012 and also had $4 million of bonds issued in 1982 that mature in February 2012. On December 31, 2011, the company's fiscal year-end, management intended to refinance both on a long-term basis. On February 7, 2012, the company issued $4 million of 20-year bonds, applying the proceeds to repay the bond issue that matured that month. In early March, prior to the actual issuance of the 2011 financial statements, Brahm Bros. negotiated a line of credit with a commercial bank for up to $7 million any time during 2012. Any borrowings will mature two years from the date of borrowing. Interest is at the prime London interbank borrowing rate.

31. Short-Term Obligations Expected to be Refinanced on a long-term basis -Management's ability to refinance the bonds on a long-term basis was demonstrated by actual financing prior to the issuance of the financial statements. -Ability to refinance $7 million of the notes is demonstrated by a refinancing agreement. -The remaining $5 million of the notes must be reported as a current liability.

32. Short-Term Obligations Expected to be Refinanced on a long-term basis The specific form of the long-term refinancing (bonds, bank loans, equity securities) is irrelevant when determining the appropriate classification.

33. ACTUAL REFINANCING E13-3 On December 31, 2007, Hattie McDaniel Company had $1,200,000 of short-term debt in the form of notes payable due February 2, 2008. On January 21, 2008, the company issued 25,000 shares of its common stock for $38 per share, receiving $950,000 proceeds after brokerage fees and other costs of issuance. On February 2, 2008, the proceeds from the stock sale, supplemented by an additional $250,000 cash, are used to liquidate the $1,200,000 debt. The December 31, 2007, balance sheet is issued on February 23, 2008. Instructions: Show how the $1,200,000 of short-term debt should be presented on the December 31, 2007, balance sheet, including note disclosure.

34. ACTUAL REFINANCING Partial Balance Sheet Current liabilities: Notes payable $ 250,000 Long-term debt: Notes payable refinanced 950,000 Total liabilities 1,200,000 Note 1: As of December 31, 2007, the company had notes payable totaling $1,200,000 due on February 2, 2008. These notes were refinanced on their due date to the extent of $950,000received from the issuance of common stock on January 21, 2008.The balance of $250,000 was liquidated using current assets.

35. REFINANCING AGREEMENT If a company signs a refinancing agreement before THE DUE DATE OF THE LOAN or before the balance sheet issue date (whichever is earlier) that clearly permits the refinancing of the Short-term debt, than the company has demonstrated the INTENT & ABILITY To refinance. => LT Liability NOTE: If the amount that can be borrowed falls into a range, than the lower end of the range is considered to be the amount borrowed. Example: $3,600,000 to $4,800,000, =>$3,600,000

36. U.S. GAAP vs. IFRS Classification of Liabilities to be Refinanced Liabilities payable within the coming year are classified as long‐term liabilities if refinancing is completed before the balance sheet date. • Liabilities payable within the coming year are classified as long‐term liabilities if refinancing is completed before date of issuance of the financial statements.

37. LOSS Contingencies • Lawsuit filed but not settled =>Loss • Collection of receivables =>BDE • Obligations for product warranties or guarantees =>Warranty Expense ====================================== A loss contingencyis an existing uncertain situation involving potential loss depending on whether some future event occurs.

38. As of the balance sheet dateORprior to the financial statement issue datea MATERIAL event must have occurred or a condition must be in existence. The outcome of that event or conditionmust be dependent upon a future event. Contingencies

39. Loss Contingencies Common loss contingencies: -Pending or threatened litigation -Guarantee and warranty costs -Premiums and coupons -Environmental liabilities -IRS Audits -Threat of expropriation of assets -Guarantees of the indebtedness of others -Actual or possible assessments or claims

40. A loss contingencyis an existing uncertain situation involving potential loss dependingon whether some future event occurs. Loss Contingencies Two factors affect whether a loss contingency must be accrued and reported as a liability: the likelihood that the confirmingevent will occur. whether the loss amount can bereasonably estimated.

41. Loss Contingencies Contingent Liability (Loss): The likelihood (that the future event will confirm the incurrence of a MATERIAL liability) can range from probable to remote. • FASB uses the following three areas of probability: • Probable. • Reasonably possible. • Remote.

42. Loss Contingencies A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.

43. Disclosure of Loss Contingencies If contingency is probable & material & can be reasonably Estimated ….. Accrue as a liability and disclose details in notes to financials If contingency is material & reasonably possible & can be… Do not accrue as a liability, but disclose details in notes to the financials If contingency is Material & remote … -Do Not accrue as a liability -Do Not disclose in notes

44. Loss Contingency Note Disclosure should include: • Nature of the contingency. • An estimate of the possible loss or range of loss.

45. Loss Contingency -RANGE The FASB requires that, when some amount within the range of expected loss appears at the time to be a better estimate than any other amount within the range, that amount is accrued. When no amount within the range is a better estimate than any other amount, the dollar amount at the low end of the range is accrued and the dollar amount at the high end of the range is disclosed.

46. Loss Contingencies Justice League Inc. is involved in a lawsuit at December 31, 2007. (a) Prepare the December 31 entry assuming it is probable that Justice League will be liable for $700,000 as a result of this suit. (b) Prepare the December 31 entry, if any, assuming it is not probablethat Justice League will be liable for any payment as a result of this suit. Lawsuit loss 700,000 Lawsuit liability 700,000 No entry is necessary! The loss is not accrued because it is not probable that a liability has been incurred at 12/31/07. NOTE DISCLOSURE is necessary if not REMOTE.

47. Gain Contingencies • Typical Gain Contingencies are: • Possible receipts of monies from gifts, donations, and bonuses. • Possible refunds from the government in tax disputes. • Pending court cases with a probable favorable outcome. • Tax loss carry-forwards (Chapter 19). Gain contingencies are not recorded. Disclosed only if probability of receipt is high.

48. Conservatism principle in accounting. Gain contingencies should not be recorded because revenue should not be recognized prior to its realization. Gain contingencies should not be disclosed in notesUNLESS probability of receipt is high.

49. Critical Thinking • Discussion:Why do you think companies are reluctant to accrue contingent liabilities? Reporting a contingent liability has an adverse effect on many key ratios. Therefore, Companies may likely consider the outcome of the event in question to be: -less than probableor -cannot reasonably be estimable.