Chapter 10 current liabilities and contingencies
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Chapter 10: Current Liabilities and Contingencies. 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.”

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Chapter 10 current liabilities and contingencies l.jpg
Chapter 10:Current Liabilities and Contingencies


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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


Reporting liabilities on the balance sheet economic consequences l.jpg

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


Current liabilities l.jpg

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


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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


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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


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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


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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


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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


Accounting for loss contingencies l.jpg

Estimable? the exact amount. Examples include warranties, coupons and lawsuits,

Yes

No

Disclose

Disclose

Ignore

Accrue &

Disclose

Accounting for Loss Contingencies

Contingent Loss

Probability of

Occurrence

Reasonably

possible

Remote

Highly

probable

Accounting

Treatment


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Ignore the exact amount. Examples include warranties, coupons and lawsuits,

Disclose

Accounting for Gain Contingencies(never recognized and rarely disclosed)

Contingent Gain

Probability of

Occurrence

Highly

Probable

Probable, Reasonably

Possible, or Remote

Accounting

Treatment


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1.Warranties the exact amount. Examples include warranties, coupons and lawsuits,

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


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2.Coupons and Premiums the exact amount. Examples include warranties, coupons and lawsuits,

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


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3.Lawsuits the exact amount. Examples include warranties, coupons and 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


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Issues and recommendations: the exact amount. Examples include warranties, coupons and lawsuits,

- 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:


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Adjusting journal entry for 2005: the exact amount. Examples include warranties, coupons and lawsuits,

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:


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(1) GJE to record sale in 2005 (200 @ $250 each): the exact amount. Examples include warranties, coupons and lawsuits,

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)


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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)


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