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Chapter Twelve
Current Liabilities and Contingencies
1. Define current liabilities & identify common CL
2. Account for accruals
3. Account for deferrals
4. Account for compensated absences
5. How to report current obligations expected to be refinanced
6. Accounting for contingencies
7. Liquidity analysis
8. Cash flows and current liabilties
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Current Liabilities
Economic obligations that are expected to be liquidated using current assets or refinanced by other current liabilities during the normal operating cycle, or within one year of the balance sheet date, whichever is longer
Accounts payable
Notes payable within one year
Dividends payable
Advances from customers or collections
Accrual for salaries, wages, commissions, rents
Current Liabilities for Competing
Companies
Ford Motor General Motors
#4 in Fortune 500 #3 in Fortune 500
Dec. 2003 Dec. 2003
Current liabilities (in millions) Current liabilities (in millions) Accounts payable $20,420 Accounts payable $ 25,422 Short-term debt 29,573 Short-term debt 0 Other current liab.. 32,295 Other curr. liab. 81,438 Total current liab. $82,288 Total current liab. 106,860.0
Potential investors should verify that each company holds sufficient current assets to meet current liability obligations.
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Accrued Liabilities
Expenses that have been incurred but not yet paid (accruals)
Salaries
Taxes
Interest
At year end, record the accrual for any unpaid expenses.
Ex. Comp. receives a utility bill for $250, but has not yet paid it:
Utilities Expense 250
Utilities Payable 250
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Critical Thinking
Discussion:
What is the impact on the
balance sheet of accruing an expense that
has been incurred but not yet paid?
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Deferred Liabilities
Adjust for amounts that have been received but have not been earned as of the end of the period (deferrals or unearned income)
Advances from customers
Refundable deposits
When advance payment is received:
Cash xxx
Deferred Revenue xxx
Deferred Revenue xxx
Income xxx
• At year end, record amount earned:
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Quick Check
What is the difference between an accrued
liability and a deferred liability?
Accrued liabilities are those expenses that
have been incurred, but not yet paid. A
deferred liability represents an amount that
has been received (advanced payment
from customers), but has not yet been
earned.
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Employee-Related Liabilities
Amounts owed to employees or other entities at the balance sheet date, but not yet paid
Reflected as current liabilities
Wages and salaries
Payroll deductions for taxes, insurance, or union dues
Bonuses
Compensated absences
Compensated Absences
Vacation and sick pay that are expected to be paid out in future periods
The employer is expected to accrue a liability for compensated absences if all of these conditions are met:
1. Employee has rendered service required to earn the benefits.
2. The obligation relates to rights that accumulate or vest.
3. Payment of compensation is probable.
4. Amount of liability can be reasonably estimated.
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Calculating Vacation Pay Accruals
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 day and 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
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Calculating Vacation Pay Accruals
• 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
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Calculating Vacation Pay Accruals
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
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Calculating Sick Pay Accruals
If sick pay vests (employee can be paid for unused days when he or she leaves the company), then sick pay must be accrued.
If sick pay does not vest, no accrual is required.
Sick pay is conceptually different from vacation pay since sick pay is dependent on a future event (illness). Vacation pay is earned as a result of past service.
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Short-Term Obligations Expected to Be
Refinanced
Loans or obligations that are due within
one year but that may not be paid off
with current assets when due
Obligation expected to be refinanced can be excluded from short-term liabilities if intentand abilityto refinance are present.
The Ability to Refinance
1. If a company issues a long-term obligation or equity securities after the balance sheet date but before the statements are issued, it has demonstrated the ability to refinance.
2. If a company signs a financing agreement before the balance sheet date that clearly permits the refinancing of the short-term debt, the company has demonstrated the ability to refinance.
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Contingencies
1. As of the balance sheet date, an event must have occurred or a condition must be in existence.
2. The outcome of that event or condition must be dependent upon a future event.
• An existing situation, condition, or set of circumstances involving uncertainty that will be resolved when one or more future events occur
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Examples of Contingencies
Lawsuit filed but not settled
Collectibility of receivables
Obligations for product warranties or guarantees
Threat of expropriation of assets
Pending or threatened litigation
Guarantees of the indebtedness of others
Actual or possible assessments or claims
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Contingency Issues
to Consider
If a contingency exists:
1. Should the company recognize an amount as a liability?
2. How likely is the potential of a loss?
3. How much should be recognized as a liability?
4. How should a loss contingency be disclosed?
5. Are gain contingencies recorded?
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Loss Contingencies
Existing circumstances involving a potential lossthat hinges on some future event
If a contingent item is both a loss contingency and is material, a liability should be accrued if:
1. The loss is probable.
2. The amount can be reasonably estimated.
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Critical Thinking
Discussion:
Why do you think companies
are reluctant to accrue contingent
liabilities?
Disclosure of Loss
Contingencies
If contingency is probable…
Accrue as a liability, disclose details in notes to financials
• If contingency is reasonably possible…
• If contingency is remote…
Do not accrue as a liability, but disclose in notes to the financials
Do not accrue as a liability or disclose in notes
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Disclosure of Loss
Contingencies
If contingency is probable and the
remote can be reasonably
estimated then accrue as a liability,
disclose details in notes to
financials.
What is a reasonable estimate?
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Warranties
An implied or expressed promise by the
seller to compensate the buyer for a
quality or quantity deficiency in a product
Usually involve a promise to replace or
repair the product if deficient; or may
involve a promise to pay a certain dollar
amount
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Warranty Liabilities
If amount of liability can be reasonably estimated at the time of the sale, report as the amount expected to be paid within one year as a current liability, the balance as a long-term liability
When the credit entry is made to record the liability, the debit is normally made to an expense account.
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Warranty Liabilities Illustrated
Illustration: Assume that Tesla Co. sells 100 cars for
$60,000 each during 2007. Each car has a warranty that covers repairs for the first three years or 36,000 miles.
Based on past history, the company estimates that repairs are 2 percent of sales. Record the following warranty liability for 2005:
Warranty Expense ($6,000,000 x 0.02) 120,000
Warranty Liability 120,000
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Warranty Liabilities Illustrated
• Assume that during 2007, repair costs on current-year sales were $56,000. The costs should be recorded:
Warranty Liability 56,000 Cash, Parts Inventory, or A/P 56,000
Cash Warranty Liabilities
Illustration: Assume that Tesla Co. sells 50 extended warranties in 2007 for $5,000 each. The warranty covers repairs for two years after the basic three-year warranty/36,000-mile warranty has expired. Record the sale as follows:
Cash 250,000 Extended Warranty Liability 250,000
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Cash Warranty Liabilities
• At year end 2010. $45,000 of repair costs were incurred under the extended warranty agreements. BigCar should record:
Warranty Expense 45,000
Cash, Parts Inventory, or A/P 45,000
Extended Warranty Liability ($250,000 x ½) 125,000
Warranty Revenue 125,000
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Premium or Coupon Offers
Premium or coupon offers represent the creation of a contingent liability
If a company sells products that include a coupon to purchase other products at a discount, the company has an obligation to sell to the customer at a discounted price. At year end, the company must estimate the number of coupons that will be redeemed and the cost of the product to be sold to establish the liability.
Expense for Coupons to Be Redeemed xxx
Estimated Liability for Coupons xxx
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Gain Contingencies
Uncertain situations that may result in a
claim to an asset or a reduction in a
liability
Gain contingencies should not be
recorded because revenue should not be
recognized prior to its realization.
Evidence of the conservatism principle in
accounting
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Liquidity Analysis and
Current Liabilities
Current Ratio = Current Assets ÷ CurrentLiabilities
Identifies the amount of current assets
available to continue business operations
Identifies how well a company is able to meet its current obligations Working Capital =
Total Assets – Total Liabilities
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Liquidity Analysis and
Current Liabilities
¾Current Ratio = Current Assets ÷ Current Liabilities
Identifies the amount of current assets available to continue business operations
Identifies how well a company is able to meet its current obligations
•Working Capital = Total Assets – Total Liabilities
Cash Flow and Current Liabilities
An increase in a current liability account indicates that less cash was paid and should be deducted on the statement of cash flows
A decrease in a current liability account indicates that more cash was paid and should be added on the statement of cash flows
• Most current liabilities are related to operating activities
• When determining actual cash flows for current liabilities, examine the balances of all current liability accounts
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Check Your Understanding
Q
What journal entry is generally made
when cash is received in advance but has
not yet been earned?
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Check Your Understanding
Q
When a company carries a short-term
loan that it expects to refinance, how does
it demonstrate the ability to refinance?
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Check Your Understanding
Q
