Chapter 10: Current Liabilities and Contingencies

1. Chapter 10:Current Liabilities and Contingencies

2. What is a liability? “Probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” Future sacrifice. Present obligations. Past transactions or events. Chapter 10: Current Liabilities and Contingencies

3. Stockholders and investors interest expense is tax deductible, but more debt means more risk to shareholders equity ownership is subordinated to creditors Creditors restrictive covenants regarding debt limits Management wants to minimize debt on the balance sheet often looks for “off-balance sheet” financing less debt now improves ability to borrow in the future Reporting Liabilities on the Balance Sheet: Economic Consequences

4. Classification expected to require the use of current assets (or the creation of other current liabilities) to settle the obligation. Valuing current liabilities on the balance sheet Ignore present value Report at face value Reporting current liabilities Primary problem is ensuring that all existing current liabilities are reported on the balance sheet. Current Liabilities

5. 1. Accounts payable - covered in Ch. 7 2. Short-term notes a. Interest bearing - record face value, and accrue interest b. Noninterest bearing - recognize interest component in “Discount” account. 3. Current maturities of long-term debts - reclassify current portion to current liabilities 4. Dividends payable - record as declared by the company (more in Chapter 12): Dividends xx Dividends Payable xx Determinable Current Liabilities

6. 5. Unearned revenues (see Chapter 5) - record in liability account until goods/services are delivered. 6. Sales taxes - record separately from sales and reflect in a liability account until remitted to taxing agency. 7. Income taxes payable - more in Appendix 10B. Determinable CL - continued

7. 8.Payroll taxes - record separately from wages/salaries and reflect in liability accounts until remitted to taxing agencies. Payroll taxes deducted from employees paychecks: FICA (Social Security) 6.2% of FICA base FICA (Medicare) 1.45% of every dollar earned FIT (Federal Income Tax) - varying percentages SIT (State Income Tax) - most states Payroll taxes paid separately by employer include: Matching FICA (both SS and Medicare) FUT (Federal Unemployment Taxes) - approx. 1% of wages to $7,000 per employee. SUT (State Unemployment Taxes) - varying % of wages to state maximum wage base per emp. Determinable CL - continued

8. 9.Accrued liabilities - accrue expense and liability at the end of the current period, and usually paid sometime during the next year. For each item, debit expense and credit liability. Examples include: Wages payable Salary payable Interest payable Rent payable Insurance payable Property taxes payable Employee bonuses Determinable CL - continued

9. Contingent on some future event or activity in order to know the exact amount. Examples include warranties, coupons and lawsuits, Alternative treatments for loss contingencies Ignore Disclose Accrue (and disclose) Alternative treatments for gain contingencies Ignore Disclose Changes in estimate may be made in subsequent periods, when future event is concluded. Contingent Liabilities

10. Estimable? Yes No Disclose Disclose Ignore Accrue & Disclose Accounting for Loss Contingencies Contingent Loss Probability of Occurrence Reasonably possible Remote Highly probable Accounting Treatment

11. Ignore Disclose Accounting for Gain Contingencies(never recognized and rarely disclosed) Contingent Gain Probability of Occurrence Highly Probable Probable, Reasonably Possible, or Remote Accounting Treatment

12. 1.Warranties Uncertain future costs Record estimated expense and liability when products are sold (matching concept): Warranty Expense xx Estimated Warranty Liability xx As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Estimated Warranty Liability xx Cash, etc. xx Contingent Liabilities - continued

13. 2.Coupons and Premiums Offered to promote sales Record estimated expense and liability when products are sold (matching concept): Promotion Expense xx Estimated Coupon Liability xx As costs are incurred, as coupons or promotional offerings are redeemed (usually in subsequent periods), charge expenditure to liability: Estimated Coupon Liability xx Cash, etc. xx Contingent Liabilities - continued

14. 3.Lawsuits If contingency should be accrued: Estimated Loss on Lawsuit xx Estimated Liability xx (and disclose information regarding case) If contingency should be disclosed, the attorneys will write a sufficient disclosure to be informative to investors, but not be incriminating to the company. Contingent Liabilities - continued

15. Issues and recommendations: - Likelihood? Probable - Disclose? Yes - Disclosure? Indicate range and level of probability. - Accrue? Since probable (or greater) and estimable, accrual is required, based on best estimate. Class Problem: P10-4, Parts a & b:

16. Adjusting journal entry for 2005: Estimated loss 742,000 Estimated liability 742,000 Journal entry at settlement (8/12/06): Estimated liability 742,000 Recovery of estimated loss 52,000 Cash 690,000 Class Problem: P10-4, Part c:

17. (1) GJE to record sale in 2005 (200 @ $250 each): Cash 50,000 Sales revenue 50,000 (2) AJE in 2005 to record estimated warranty for the sales (200 @ $20): Warranty expense 4,000 Estimated Warr. Liability 4,000 (3) GJE to record payment in 2005 for repairs: Est. Warr. Liability 1,400 Cash 1,400 GJE to record payment in 2006 for repairs: Est. Warr. Liability 2,600 Cash 2,600 Class Exercise: E10-10(a)

18. Income effects for the revenue and warranty expense under the two alternative for recognition of expense (expressed in thousands): Accrue Expense Expense as Paid 2005 20062005 2006 Revenues 50,000 --- 50,000 --- Warr. Expense (4,000) --- (1,400) (2,600) Note that the accrual method recognizes the expense in the same period as the revenues generated by the sale. Class Exercise: E10-10(b)