Chapter 13 Current Liabilities and Contingencies – Flashcards

Liabilities and owners' equiy accounts represent specific souces of a company's assets.

Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements. Some liabilities are not contractual obligations and may not be payable in cash. A liability has three essential characteristics: 1. Are probable, future sacrifices of economic benefits 2. Arise from present obligations (to transfer goods or provide services) to other entities 3. Result from past transactions or events. It is a present responsibility to sacrifice assets in the future because of a transaction or other event that happened in the past.

Current liabilities are expected to require current assets and usually payable within one year. Classifying liabilities as either current or long term helps investors and creditors assess the relative risk of a business's liabilities. Current liabilities ordinarily are reported at their maturity amounts. Common current liabilities include: accounts payable, notes payable, commercial paper, income tax liability, dividends payable, and accrued liabilities. Amounts reported on the face of the balance sheet seldom are sufficient to adequately describe current liabilities. Additional descriptions are provided in disclosure notes.

Accounts payable are obligations to suppliers of merchandise or of services purchased on open account. Most trade credit is offered on open account. because the time period is usually short, these liabilities typically are noninterest bearing and are reported at their face amounts. Trade notes payable differe from accounts payable in that they are formally recognized by a written promissory notes. Often these are of a somewhat longer term than open accounts and bear interest.

The most common way for a corporation to obtain temporary financing is to arrange a short term bank loan. When a company borrows cash from a bank and signs a promissory note, the firm's liability is reported as notes payable.

A line of credit allows a company to borrow cash without having to follow formal loan procedures and paperwork. A non-committed line of credit is an informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and paperwork. A committed line of credit is a more formal agreement that usually requires the firm to pay a commitment fee to the bank.

face amount X Annual rate X time to maturity

Noninterest-bearing loans actually do bear interest, but the interest is deducted fromt eh face amount to determine the cash proceeds made available to the borrower at the outset. When interest is discounted from the face amount of the note, the effective rate is higher than the stated discount rate.

Sometimes short term loans are secured meaning a specified asset of the borrower is pledged as collateral or security for the loan. Inventory of accounts receivable are often pledged as security for short term loans.

Large, highly rated firms soemtimes sell commercial paper to borrow funds at a lower rate than through a bank loan. Commercial paper refers to unsecured notes sold in minimum denominations of $25, 000 with maturities ranging from 30 tp 270 days. Interest is often discounted at teh issuance of the note. It is usually issued directly to the buyer (lender) and is backed by a line of credit with a bank. This allows the interest rate to be lower than in a bank loan. the name commercial paper refers to the fact that a paper certificate tradtionally is issued to the lender to signify the obligation. Commerical paper is aform of notes payable.

Accrued liabilities represent expenses already incurred but not yet paid. These liabilities are recorded by adjusting entries at the end of the reporting period/, prior to preparing the financial statements.

Accrued interest payabel arises in connection with notes like those discurred earlier in this chapter.

Comepnsation for employee services can be in the form of hourly wages, salary, commissions, bonuses, stock compensation plans, and pensions. Accrued liabilities arise in connection with compensation expense when employees have provided services byt have not yet been paid as of a financial statement date. These accrued expenses/ accrued liabilities are recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements.

An employer should accrue an expense and the related liability for employees' compensation for future absences if the obligation meets all of the four conditions listed below 1/ The obligation is attributable to employees' services already performed. 2. The paid absence can be taken in a later year- the benefit vests (will be compensated even if the employment is terminated or the benefit can be accumulated over time. 3. payment is probable. 4. The amount can be reasonably estimated. These conditions are consistent with the requirement that we accrue loss contingencies only when the obligation is both probable and can be reasonably estimated. When the necessary conditions are met, compensated future absences are accrued in the year the compensation is earned. Customary practice should be considered when deciding whether an obligation exists. Custom and practice also influence whether unused rights to paid absences expire of can be carried forward. Accrual of sick pay is not required, but may be appropriate in some circumstances.

A wide variety of bonus plans provide compensation tied to performance other than stock prices. Bonuses sometimes take the place of permanent annual raises.

Liabilities are created when amounts are received that will be returned or remitted to others. Collecting cash from a customer as a refundable deposit or as an advance payment for products or services creates a liability to return the deposit or to supply the products or services. Illustration 13-9 and -10 Customer advances are also known as unearned revenue or deferred revenue and represent liabilities until the related product or service is provided. A customer advance produces an obligation that is satisfied when the product or service is provided. Unearned revenue gets reduced when the revenue associated with the advance has been earned, either because the seller has delivered the goofd or services as promised or becasue the buuyer has forfeited the advance payment. When reveune recognition is delayed, but some advance payment is received, the seller reports an unearned revenue liability until delivery has occured.

Gift cards or certificates are common forms of advanced payments. When a company sells a gift card, it initally records the cash received as unearned revenue, and thne recognizes revenue either when the gift card is redeemed or when the probability of redemption is viewed as remote.

Companies often make collections for third parties from customers or from employees and periodically remit these amounts to appropriate governmental or other units. Amounts collected this way represent liabilities until remitted. Example: Sales tax. Payroll-related deductions such as withholding taxes, etc, also create current liabilities until the amounts collected are paid to appropriate parties.

Management would most likely choose to classify an obligation as non current because most consider debt that is payable currently to be riskier than debt that doesn't need to be paid for some time because the current payable requires the company to access the cash relatively soon. the long term classification allows the company to record higher working capital (currents assets minus current liabilities) and a higher current ratio (current assets/ current liabilities)/

Long-term obligations usually are reclassified and reported as current liabilities when they become payable within the upcoming year.

The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year, even if the debt is not expected to be called. The current liabilitiy classification also is intended to include situations in which the creditor has the right to demand payment becasue an existing violation of a provision of the debt agreement makes it callable.

Short term obligations can be reported as non current liabilities if the company intends to refinance on a long term basis and demonstrates the ability to do so by a refinancing agreement or by actual financing.

the feature that distinguished loss contingencies from liabilities is uncertainty as to whether or not an obligation really exists.

A loss contingency involves an existing uncertainty as to whether a loss really exists, where the uncertainty will be resolved only when some future event occurs. Whether a contingency is accrued and reported as a liability depends on the likelihood that the confirming event will occur and what can be determined about the amount of loss. The event that gives rise to the potential liability must occur before the financial statement date. Regardless of the likelihood of the eventual outcome, no liability could have existed at the statement date. GAAP require that the likelihood that the future events will confirm the incurrence of the liability be categorized as probable, reasonably possible, or remote. The amount of the potential loss is classified as either known, reasonably estimable, or not reasonably estimable. If one amount within a range of possible loss appears better than other amounts within the range, that amount is accrued. When no amount within the range appears more likely than others, the minimum amount should be recorded and the possible additional loss should be disclosed. Some contingent losses don't involve liabilities at all. These contingencies, when resolved, cause a noncash asset to be impaired, so accruing the contingency means reducing the related asset rather than recording a liability. Not all loss contingencies are accrued. If one or both criteria for accrual are no met, but there is at least a reasonable possibility that a loss will occur, a disclosure note should describe the contingency with an estimate of the potential loss. Illustration 13-16 page 754

Most consumer products are accompanied by a guarantee. Any costs of making goods on such guarantees should be estimated and recorded as expenses in the same accounting period the products are sold. It is in the period of the sale that the company becomes obligated to eventually make good on a guarantee, so it makes sense that i recognizes a liability in the period of the sale. This is a loss contingency because the cost of satisfying the guarantee usually comes much later. There may be a future sacrifice of economic benefits due to an existing circumstance that depends on an uncertain future event. The criteria for accruing a contingent loss almost always are met for product warranties. While we usually can't predict the liability associated with an individual sale, reasonably accurate estimates of the total liability for a period usually are possible because prior experience makes it possible to predict how many warranties or guarantees will need to be satisfied. The costs of satisfying guarantee should be recorded as expenses in the same accounting period the products are sold.

SFAC No. 7 provides a framework for using future cash flows in accounting measurements. It offers a way to take into account any uncertainty concerning the amounts and timing of the cash flows. When the warranty obligation spans more than one year and we can associate probabilities with possible cash flow outcomes, the approach offers a more plausible estimate of the warranty obligation. It incorporates specific probabilities of cash flows into the analysis. The probability weighted cash outsomes provide the expected cash flows. The present value of the expected cash flows is the estimated liability.

An extended warranty provides warranty protection beyond the manufacturer's original warranty. Because an extended warranty is priced and sold separately from the waranteed product, it constitutes a separate sales transaction. When should the revenue from the sale of an extended warranty be recognized? Because the earnings process for an extended warranty continues over the entire warranty period, revenue should be recognized over the same period. Cash is earned upfront, revenue is deferred as an "unearned revenue" liability at the time of the sale and recognized as revenue over the contract period, typically on a straight line basis. The costs incurred to satisfy customer claims under the extended warranties also will be recorded during the same warranty period.

Cash register receipts, bar codes, rebate coupons, or other proofs of purchase often can be mailed to the manufacturer for cash rebates. Sometimes promotions offer premiums other than cash to buyers of certain products. The estimated amount of the cash rebates or the cost of the non cash premiums estimated to be given out represents both an expense and an estimated liability in the reporting period the product is sold. the costs of promotional offers should be recorded as expenses in the same accounting period the products are sold.

Pending litigation is not unusual. Companies may accrue estimated lawyer fees and other costs, but they do not usually record a loss until after the ultimate settlement has been reached or negotiations for settlement are substantially completed. While companies should proved extensive disclosure notes, this does not always happen.

When the cause of a loss contingency occurs before the year-end, a clarifying event before financial statements are issued can be used to determine how the contingency is reported. Several weeks usually pass between the end of a company's fiscal year and the date the financial statements for that year are actually issued or available to be issued. If information becomes available that sheds light on a claim that existed when the fiscal year ended, that information should be used in determining the probability of a loss contingency materializing and in estimating the amount of the loss. For a loss contingency to be accrued, the cause of the lawsuit must have occurred before the accounting period ended. If an event giving rise to a contingency occurs after the year-end, a liability should not be accrued. Any event occurring after the fiscal year end but before the financial statements are issued that has a material effect on the company's financial position must be disclosed in a subsequent events disclosure note.

It must be probable that an unasserted claim or assessment or an unfiled lawsuit will occur before considering whether and how to report the possible loss. Even if a claim has yet to be made when the financial statements are issued, a contingency may warrant accrual or disclosure. In this case a two step process is involved in deciding how the unasserted claim should be reported: 1. Is the claim or assessment probable? No- stop. Yes- see #2 2. If the claim or assessment is probably, the decision as to whether or not a liability is accrued or disclosed is the same as it is when a claim or assessment already has been asserted, requiring evaluation of a) the likelihood of an unfavorable outcome and b) whether the dollar amount can be estimated. The inherent uncertainty involved with contingent liabilities means additional care is required to determine whether future sacrifices of economic benefits are probable and whether the amount of the sacrifices can be quantified.

A gain contingency is an uncertain situation that might result in a gain. Gain Contingencies are not accrued. The nonparallel treatment of gain contingencies is an example of conservatism, following the reasoning that it's desirable to anticipate losses, but recognizing gains should await their realization. Material ones are disclosed in the notes, but care should be taken that the disclosure note not give misleading implications as to the likelihood of realization.