Other Liabilities

1. Other Liabilities 21 Other liabilities both current and long term • Learning Objectives • Account for estimated liabilities involving warranties and rebates • Account for estimated liabilities arising from compensated absences and bonus plans • Explain accounting issues involving estimated and deferred income tax • Explain accounting issues involving contingent liabilities • Analysis: Compute and explain working capital as a percentage of sales

2. The FASB definition of a liability includes these 3 essential elements: It is an obligation in effect that must be settled by giving up cash, goods or services in the future. It is an obligation that cannot be avoided. The event that created the obligation has already occurred. Liabilities -definition In this chapter we will study several liabilities that could meet this definition but may: • Require an estimate as to • the size of the liability, • the date it must be paid and • the party to whom it will be paid • Exhibit uncertainty as to whether the liability will occur

3. Objective 21.1: Account for estimated liabilities involving warranties and rebates Estimated liabilities are known obligations of an uncertain amount. They often also exhibit uncertainty as to the date they must be paid and the party to whom they will be paid. O21.1

4. Account for estimated liabilities involving warranties and rebates Firms often guarantee their products and services under a warranty agreement. Based on the expected occurrence of claims, they must follow the Matching Concept and expense the warranty repair or replacement in the same fiscal period as the sales that involved the warranty. WARRANTY We guarantee. . . O21.1 Matching Concept

5. Account for estimated liabilities involving warranties and rebates Firms also offer inducements to generate sales and develop customer loyalty through the use of marketing innovations such as cash rebates. This additional expense, must follow the Matching Concept and be included in the same fiscal period as the sales that these inducements helped generate. $25 Rebate With the purchase of. . . O21.1 Matching Concept

6. Account for estimated liabilities involving warranties and rebates • Problem -When the warranty or rebate is expensed, the firm doesn’t know precisely: • Who will be paid • How much or how many will be paid • When they will be paid Solution -Estimate the warranty and rebate expense expected O21.1

7. Account for estimated liabilities involving warranties and rebates • Warranty liabilities • After sale obligations arising from guaranty agreements for products and services • Estimates must be used to predict expected warrantyclaims • Warranty liability and expense must be recorded in the same period as sales subject to the warranty WARRANTY We guarantee. . . O21.1

8. Account for estimated liabilities involving warranties and rebates • Rebate liabilities • Subject to a sale, cash, product or service obligation to a customer • Estimates must be used to predict amounts that must be paid based on expected redemption rates • Rebate liability and expense must be recorded in the same period as the sales subject to the incentive $25 Rebate With the purchase of. . . O21.1

9. ExampleWARRANTY–On January 1, Greenline Engine Rebuilders began to offer a 2 year 20,000 mile parts and labor warranty on their rebuilt auto and truck engines. Management estimates that warranty expenses will average 3% of net sales. As of December 31, net sales = $2,350,000. Estimated warranty claims are: $2,350,000 x 3% = $70,500 Greenline will report $70,500 less net income as a result of this adjustment. O21.1

10. ExampleWARRANTY–In January following the first year of the warranty agreement, a customer submitted a claim for $500 for warranty repairs made on a Greenline engine.   No change in net income as a result of this transaction Note that the debit does not go to an expense account, it reduces the Warranty Liability. This obligation has already been expensed in the prior fiscal period. O21.1

11. Example REBATE –On January 1, YardMax Tools began to offer a $25 mail-in rebate on the purchase of their new garden tiller. Management estimates that 40% of customers will submit the mail-in rebate. The sales price for the new tiller is $425. Sales totaled $850,000. Estimated rebate expense: $850,000/$425 = 2000 tillers x 40% x $25 = $20,000 YardMax will report $20,000 less net income O21.1

12. Objective 21.2: Account for estimated liabilities arising from compensated absences and bonus plans • Compensated absence plans include: • Vacations • Sick pay • Holidays • Family leave • earned by employees O21.2

13. Account for estimated liabilities arising from compensated absences and bonus plans • FASB rules indicate these expenses should be accrued if the following conditions are met: • The obligation to compensate for absences arises from services already rendered by the employee. • The obligation is related to rights for time off that vest or accumulate • Payment is probable • Amounts can be reasonably estimated O21.2

14. Account for estimated liabilities arising from compensated absences and bonus plans Vested rights exist when the employee has a right to the benefit even if terminated Accumulated rights exists when benefits can be carried forward into future periods if not used in the current period O21.2

15. Consider start up firm Barrier Systems who began operation on July 1 (FYE 6/30). Barrier has 10 employees who earn, on average, $625 per week. Compensated absences -example During the year employees earned 20 weeks of paid vacation and none was used. $625 x 10 employees x 20 weeks = $125,000 O21.2

16. In the first month of the subsequent fiscal year, employee Ralph Tonga takes his 2 week vacation. His weekly wage, net of all payroll costs and deductions, is $725.   Compensated absences -example Additional entries (i.e. debits to the Vacation Wages Payable & credits to various payroll payable accounts) for employee deductions and the employerpayroll costs would be necessary to complete the payroll recording. (See Chapter 8) O21.2

17. Ridlow Corporation’s bonus plan pools 20% of net profits (after the expense of the profit sharing is deducted) for distribution to all employees weighted by their total annual compensation. Ridlow’s net income before any bonus plan deductions is $1,500,000. Let B equal the amount of the bonus, then: B = 20% x ($1,500,000—B) B = $300,000 - .20B 1.20B = $300,000 B = $250,000 Bonus agreements -example O21.2

18. Objective 21.3: Explain accounting issues involving estimated and deferred income tax • The regular C-corporation is subject to federal income taxes which must be accounted for on the corporate financial statements • Estimates are recorded during the tax year based on anticipated taxable income levels • Corporations are required to make estimated quarterly income tax payments to the IRS to avoid penalties O21.3

19. Explain accounting issues involving estimated and deferred income tax At month end, Nappy Corp estimates the first quarterly tax payments due April 15 to be $22,000. Note that the estimate is expensed O21.3

20. Explain accounting issues involving estimated and deferred income tax On April 15, the tax payment is made The payable is satisfied with the cash payment O21.3

21. Explain accounting issues involving estimated and deferred income tax • Deferred Income Tax Liabilities • income under GAAP and income under IRS rules is usually different • most differences are temporary* due to timing issues • over longer periods of time (years) different income amounts between IRS and GAAP due to timing are eliminated • *except for some permanent differences O21.3

22. Explain accounting issues involving estimated and deferred income tax Consider the different income for the same year under GAAP and IRS for Vision Corporation: O21.3 Vision Corporation 12/31/10 Vision Corporation 12/31/10 GAAP Pre-tax net Income $30,000 IRS Pre-tax net Income $10,000

23. Explain accounting issues involving estimated and deferred income tax Why is the income (GAAP vs IRS)different? • Some examples of permanent reasons are: • PermanentGAAP IRS • Is municipal bond interest revenue? • Are fines for legal violations expenses? For temporary and permanent reasons. No Yes No Yes O21.3

24. Explain accounting issues involving estimated and deferred income tax Why is the income (GAAP vs IRS) different? Due to temporary timing differences in the recognition of revenues and expenses • Some examples of temporary reasons are: (eventually results will be same for GAAP & IRS) • Straight line depreciation could be used for GAAP but an accelerated depreciation for IRS • Uncollectible account expense and warranty expense is accrued under GAAP but IRS only allows these to be expensed when cash is actually paid O21.3

25. Explain accounting issues involving estimated and deferred income tax These differences often result in a deferred income tax liability(or asset) Keep in mind that we are preparing GAAP statements here GAAP statements We are obliged to record the federal income tax expense based on the $30,000 GAAP income –NOT the $10,000 IRS taxable income. O21.3 Vision Corporation 12/31/10 Vision Corporation 12/31/10 GAAP Net Income $30,000 IRS Net Income $10,000

26. Explain accounting issues involving estimated and deferred income tax If the tax rate is 15% for Vision Corporation, this would require: 15% x $30,000 = $4,500 debit to income tax expense The amount currently due (must be paid this period) to the IRS: 15% x $10,000 = $1,500 The balancing entry of $3,000 is the deferred amount (will be paid in future years) O21.3

27. These differences can also result in a deferred income tax asset Explain accounting issues involving estimated and deferred income tax Consider Cascade Corporation net income of $20,000 under GAAP and $50,000 under IRS. The deferred tax asset will be used up in future periods. O21.3

28. Objective 21.4: Explain accounting issues involving contingent liabilities Contingent liabilities are potential liabilities arising from an existing set of circumstances Example: Consider a product defect lawsuit pending against PNC Corporation. If the firm loses the suit they may be required to pay substantial amounts. O21.4

29. Explain accounting issues involving contingent liabilities Depending on how future events unfold, PNC Corporation could suffer a loss based on the outcome of the lawsuit. The loss is uncertain until the lawsuit is over O21.4

30. Explain accounting issues involving contingent liabilities • FASB rules regarding the recording of contingent liabilities are based on two questions: • What are the chances the event will occur? • Can the size of the potential loss be reasonably estimated? O21.4

31. Explain accounting issues involving contingent liabilities • FASB assigns three ranges of possibility to the first question. • Probable –The future event is likely to occur • Reasonably possible –The chance of the event occurring is less than likely but more than remote • Remote –The chance of the future event occurring is slight O21.4

32. Explain accounting issues involving contingent liabilities Only one of these situations require the liability to be recorded O21.4

33. Assuming that the PNC corporation product defect lawsuit has been determined to be both probable and can be reasonably estimated as a 500,000 potential loss. . . Explain accounting issues involving contingent liabilities The loss is still probable, not 100% certain O21.4

34. Explain accounting issues involving contingent liabilities • Also: • A set of circumstances could possibly result in a gain (i.e. the firm began a lawsuit against another party for damages) • If the firm wins, a gain could result • However, GAAP rules lean toward the Conservatism Concept in the case of gains and they are not recorded until they actually occur O21.4

35. Objective 21.5: Analysis: Compute and explain average working capital as a percentage of sales Working capital answers the following question: How many dollars of current assets would remain if all current liabilities were paid using current assets? The higher the number, the more liquidity is displayed by the balance sheet. Working Capital Current Assets Current Liabilities O21.5

36. Analysis: Compute and explain average working capital as a percentage of sales Average working capital = Working capital (beg.) + Working capital (ending) 2 Average working capital as a percentage of sales Average Working Capital Sales O21.5

37. Analysis: Compute and explain average working capital as a percentage of sales Average working capital as a percentage of sales answers the question: “What level of working capital was necessary to achieve the reported sales for the year?” Average Working Capital Average working capital as a percentage of sales Sales O21.5

38. Example O21.5

39. End Unit 21