Section 13 Liabilities

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1 15-1 Section 13 Liabilities Probable future sacrifices of economic benefits. Arise from present obligations to other entities. Result from past transactions or events.

What is a Current Liability? 15-2 LIABILITIES Current Liabilities Obligations payable within one year or one operating cycle, whichever is longer.

2 What is a Current Liability? 15-2 LIABILITIES Current Liabilities Obligations payable within one year or one operating cycle, whichever is longer. Expected to be satisfied with: current assets or the creation of other current liabilities. Long-term Liabilities Note: Operating cycle The time span from when cash is used to acquire goods and services until cash is received from the sale of goods and services. Operating: refers to company operations Cycle: refers to the circle flow of cash used for co. inputs and then cash received from its outputs. Length of a cycle: Service co: the time span between (1) paying employees who perform the services & (2) receiving cash from customers. Merchandiser: the time span between (1) paying suppliers for merchandise and (2) receiving cash from customers.

3 15-3 Current Liabilities Accounts payable Taxes payable (Fed, State, Local) Unearned revenues Current Liabilities Cash dividends payable Accrued expenses Short-term notes payable

4 15-4 Accrued Expenses: Compensation expenses: such as salaries, commissions, and bonuses are liabilities at the balance sheet date if earned but unpaid. Accrued expenses/accrued liabilities: are recorded with an adjusting entry at period end, prior to preparing financial statements.

5 CASH-BASIS ACCOUNTING vs. ACCRUAL-BASIS ACCOUNTING 15-5 Most companies use accrual-basis accounting recognize revenue when it is earned and expenses in the period incurred, without regard to the time of receipt or payment of cash. Under the strict cash-basis, companies record revenue only when they receive cash, and record expenses only when they disperse cash. Cash basis financial statements are not in conformity with GAAP.

6 CASH-BASIS ACCOUNTING vs. ACCRUAL-BASIS ACCOUNTING Conversion From Cash Basis To Accrual Basis Example: Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2012, Dr. Windsor received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 - $170,000). At January 1 and December 31, 2012, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in following Illustration. 15-6

7 CASH-BASIS ACCOUNTING vs. ACCRUAL-BASIS ACCOUNTING 15-7 Cash Accounts Receivalbe All Collections in 2012 (plug #) 293,000 1/1/ ,000 A/R Collection in ,000 Unearned Revenue 4,000 All Payments in 2012 (plug) 169,100 Prepaid in Collection in ,000 12/31/ ,000 12/31/2012 9,000 Accrual Basis: 120,400=130,000-3,000-4, , ,100 = 170, Unearned Revenue 1/1/ ,000= Unprovided service in , ,000-3,000-4,000 12/31/2012 4,000 Prepaid Expense 1/1/2012 1,800 New prepaid incurred in /31/2012 2,700 Accrued Salary Payable 1/1/2012 2,000 Unpaid expense in ,500 12/31/2012 5,500

8 CASH-BASIS ACCOUNTING vs. ACCRUAL-BASIS ACCOUNTING 15-8 Conversion From Cash Basis To Accrual Basis 120,400 = 130,000-3,000-4, ,500 Converting back from Accrual to Cash basis: 120, , , ,500 = 130,000 (Cash) Or, 130,000 = NI + 3,000+4, ,500 NI = 120,400 (Accrual basis)

9 15-9 REVERSING ENTRIES (Not Required) With or Without Reversing Entries for Accruals Example: Notes: assuming 10/31 is period end for closing books.

10 USING REVERSING ENTRIES Summary of Reversing Entries, If Used 1. Accrued expenses and revenue: may be reversed; revenue earned but cash not collected or expenses incurred but not paid. 2. Deferred (Unearned or future) revenue: for which a company debited cash and credited Unearned Revenue. No reversing entries, but adjusting entries are needed when services are rendered. (Note: Deferred charges (see slide 23) bond issue costs, amortized, not reversed. Deferred income taxes - When book income > taxable income: Dr. Income tax Cr. Income tax payable (current, due) Deferred (future) tax liability (no reversing; see slide 22-37) Note: Adjusting entries - depreciation and amortization; never reverse.

15-11 Troubled Debt Restructuring When changing the original terms of a debt agreement is motivated by financial difficulties experienced by the debtor (borrower), the new arrangement is referred to

11 15-11 Troubled Debt Restructuring When changing the original terms of a debt agreement is motivated by financial difficulties experienced by the debtor (borrower), the new arrangement is referred to as a troubled debt restructuring. A troubled debt restructuring may be achieved in either of two ways: 1.The debt may be settled at the time of the restructuring. 2.The debt may be continued, but with modified terms.

Debt Settled at Time of Restructuring - Example 15-12 First Prudent Bank is holding a $30,000,000 note from the developer of some property.

12 Debt Settled at Time of Restructuring - Example First Prudent Bank is holding a $30,000,000 note from the developer of some property. The developer is in financial trouble and cannot pay the bank the amount owed. The bank agrees to accept land with a fair value of $20,000,000 in full settlement of the note. The property is carried on the books of the developer at $17,000,000. The entries on the books of the developer to record the settlement: Land... 3,000,000 Gain on disposal of land... 3,000,000 ($20,000,000 less carrying value of $17,000,000) Note payable... 30,000,000 Gain on troubled debt restructuring. 10,000,000 Land. 20,000,000

Debt is Continued with Modified Terms - Example 15-13 Example: the total cash payments are less than the carrying amount of the debt.

13 Debt is Continued with Modified Terms - Example Example: the total cash payments are less than the carrying amount of the debt. First Prudent Bank holds a $30,000,000 note from a property developer. The note bears interest at 10%, and matures in 2 years. The developer is in financial difficulty and the bank agrees to modify the terms of the agreement as follows: 1. Forgive or reverse the interest accrued last year of $3,000,000, un-accrued interest is irrelevant as loan terms will be modified. 2. Adjust or reduce the interest payments to $2,000,000 each year. 3. Reduce the principal amount to $25,000,000. Principal Interest Total Carrying amount $ 30,000,000 $ 3,000,000 $ 33,000,000 Future payments 25,000,000 4,000,000 29,000,000 Gain to developer $ 4,000,000

14 15-14 Debt is Continued with Modified Terms At the date of the new agreement, the following journal entry is required: Accrued interest payable... 3,000,000 Note payable - old... 30,000,000 Gain on debt restructuring. 4,000,000 Note payable new. 29,000,000 Net Notes Payable $29,000,000 (total future cash payments including new principal and new interests) At each of the next two interest payments, make the following entry: Note payable... 2,000,000 Cash 2,000,000

15 Debt is Continued with Modified Terms - Summary Amount Face amount of old note $ 30,000,000 Entry at date of restructuring (1,000,000) First interest payment (2,000,000) Second interest payment (2,000,000) Maturity value of note $ 25,000,000 At maturity, the developer will make the following entry: Note payable... 25,000,000 Cash 25,000,000

16 Current Maturities of Long-Term Debt Long-term obligations (bonds, notes, lease liabilities, deferred tax liabilities) usually are reclassified and reported as current liab. when they become payable within the operating year (or operating cycle, if longer than a year). Exclude long-term debts maturing currently as current liabilities if they are to be: 1. Retired by assets accumulated that have not been shown as current assets, 2. Refinanced, or retired from the proceeds of a new debt issue, or 3. Converted into capital stock.

Short-Term Obligations Expected to be Refinanced 15-17 May reclassify a short-term liability as

and It has demonstrated the ability to refinance.

17 Short-Term Obligations Expected to be Refinanced May reclassify a short-term liability as long-term if two conditions are met: It has the intent to refinance on a long-term basis. and It has demonstrated the ability to refinance. The ability to refinance on a long-term basis can be demonstrated by an existing refinancing agreement, or actual financing prior to issuance of the financial statements.

18 15-18 Short-Term Obligations Expected to be Refinanced - Cont d Mgmt. Intends of Refinance YES Demonstrates Ability to Refinance Actual Refinancing after balance sheet date but before issue date YES or NO NO Classify as Current Liability Financing Agreement Noncancellable with Capable Lender Exclude Short-Term Obligations from Current Liabilities and Reclassify as LT Debt Note: treated differently from subsequent event

19 Subsequent Events 1. Conditions existed on the Balance Sheet Date (year end date), e.g., the bankruptcy of a customer 10 days after the balance sheet date usually reflects the poor financial health that existed on the balance sheet date, and the estimate of bad debts may therefore need to be revised to reflect the new info. (i.e., if estimated losses incurred prior to balance sheet date but settled subsequently (before issuance date); should be accrued as of balance sheet date] Cause of Loss Contingency Clarification Year End Date (Balance Sheet Date) Financial Statements issue Date Financial Statement Period Subsequent Events Period

Subsequent Events 2. Evidence of conditions (events) occurring after the year-end date (balance sheet date) but before the financial statements issued, if the possible loss would cause the fin.

20 Subsequent Events 2. Evidence of conditions (events) occurring after the year-end date (balance sheet date) but before the financial statements issued, if the possible loss would cause the fin. Statements to be misleading, it should be disclosed on the financial statements. E.g., the loss of inventories or plant assets due to a casualty, a sale of bond or capital stock issue Cause of Loss Contingency Clarification Fiscal Year Ends Financial Statements issued

Refinancing of Short-Term Debt - Example 15-21 On December 31, 2010, Alexander Company had $1,200,000 of short-term debt in the form of notes payable due February 2, 2011.

21 Refinancing of Short-Term Debt - Example On December 31, 2010, Alexander Company had $1,200,000 of short-term debt in the form of notes payable due February 2, On January 21, 2011, the company issued 25,000 shares of its common stock for $36 per share, receiving $900,000 proceeds after brokerage fees and other costs of issuance. On February 2, 2011, the proceeds from the stock sale, supplemented by an additional $300,000 cash, are used to liquidate the $1,200,000 debt. The December 31, 2010, balance sheet is issued on February 23, Instructions: Show how the $1,200,000 of short-term debt should be presented on the December 31, 2010, balance sheet, including note disclosure

22 Refinancing of Short-Term Debt - Example Cont d Partial Balance Sheet Current liabilities: Notes payable (not refin ed by NP) Long-term debt: Notes payable refinanced (via CS) Total liabilities $ 300, ,000 $1,200,000

23 Asset Retirement Obligations Environmental Liabilities (e.g., mines, nuclear power plants) A company must recognize an asset retirement obligation (ARO) when it has an existing legal obligation associated with the retirement of a long-lived asset and when it can reasonably estimate the amount of the liability. NOTE: The SEC argues that if the liability is within a range, and no amount within the range is the best estimate, then management should recognize the minimum amount of the range.

24 15-24 Environmental Liabilities Cont d Obligating Events. Examples of existing legal obligations, which require recognition of a liability include, but are not limited to: decommissioning nuclear facilities, dismantling, restoring, and reclamation of oil and gas properties, certain closure, reclamation, and removal costs of mining facilities, closure and post-closure costs of landfills.

25 15-25 Environmental Liabilities Example On January 1, 2010, Wildcat Oil Company erected an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and remove the platform at the end of its useful life, estimated to be five years. Wildcat estimates that dismantling and removal will cost $1,000,000. Based on a 10 percent discount rate, the fair value of the asset retirement obligation is estimated to be $620,920 ($1,000,000 x PV of $1). Wildcat records this ARO as follows. Drilling platform 620,920 Asset retirement obligation 620,920

26 Environmental Liabilities Example Cont d During the life of the asset, Wildcat allocates the asset retirement cost to expense. Using the straight-line method, Wildcat makes the following entries to record this expense. December 31, 2010, 2011, 2012, 2013, 2014 Depreciation expense ($620,920 / 5) 124,184 Accumulated depreciation 124,184

27 Environmental Liabilities Example Cont d Illustration: On January 10, 2015, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the platform at a contract price of $995,000. Wildcat makes the following journal entry to record settlement of the ARO. January 10, 2015 Asset retirement obligation 1,000,000 Gain on settlement of ARO 5,000 Cash 995,000

15-28 Contingencies An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will

28 15-28 Contingencies An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. * * Accounting for Contingencies, Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 1

29 15-29 Gain Contingencies Typical Gain Contingencies are: 1. Possible receipts of monies from gifts, donations, and bonuses. 2. Possible refunds from the government in tax disputes. 3. Pending court cases with a probable favorable outcome. 4. Tax loss carryforwards. Gain contingencies are not recorded. Disclosed only if probability of receipt is high.

30 15-30 Contingent Liability Loss Contingencies The likelihood that the future event will confirm the incurrence of a liability can range from probable to remote. FASB uses three areas of probability: Probable. Reasonably possible. Remote.

31 15-31 Loss Contingencies Probability Probable Reasonably Possible Remote Accounting Accrue Footnote Ignore

15-32 Loss Contingencies - Example Scorcese Inc. is involved in a lawsuit at December 31, 2010.

32 15-32 Loss Contingencies - Example Scorcese Inc. is involved in a lawsuit at December 31, (a) Prepare the December 31 entry assuming it is probable that Scorcese will be liable for $900,000 as a result of this suit. (b) Prepare the December 31 entry, if any, assuming it is not probable that Scorcese will be liable for any payment as a result of this suit. (a) Lawsuit loss 900,000 Lawsuit liability 900,000 (b) No entry is necessary. The loss is not accrued because it is not probable that a liability has been incurred at 12/31/10.

33 Loss Contingencies 15-33

34 15-34 Loss Contingencies Common loss contingencies: 1. Litigation, claims, and assessments. 2. Guarantee and warranty costs. 3. Premiums and coupons. 4. Environmental liabilities.

35 15-35 Loss Contingencies Guarantee and Warranty Costs Promise made by a seller to a buyer to make good on a deficiency of quantity, quality, or performance in a product. If it is probable that customers will make warranty claims and a company can reasonably estimate the costs involved, the company must record an expense.

36 15-36 Extended Warranty Contracts Extended warranties are sold separately from the product. The related revenue is unearned until: Claims are made against the extended warranty, or The extended warranty period expires.

37 15-37 Guarantee and Warranty Costs Two basic methods of accounting for warranty costs: 1. Cash-Basis method Expense warranty costs as incurred, because 1. it is not probable that a liability has been incurred, or 2. it cannot reasonably estimate the amount of the liability.

38 15-38 Guarantee and Warranty Costs Two basic methods of accounting for warranty costs: 2. Accrual-Basis method Charge warranty costs to operating expense in the year of sale of the related products. Method is the generally accepted method. Referred to as the expense warranty approach.

39 15-39 Warranty Expense - Example Streep Factory provides a 2-year warranty with one of its products which was first sold in In that year, Streep spent $70,000 servicing warranty claims. At year-end, Streep estimates that an additional $400,000 will be spent in the future to service warranty claims related to 2010 sales. Prepare Streep s journal entry to record the $70,000 expenditure, and the December 31 adjusting entry Warranty expense 70,000 Cash, Inventory, Payroll 70,000 12/31/10 Warranty expense 400,000 Warranty liability 400,000

40 15-40 Premiums and Coupons Companies should charge the costs of premiums and coupons to expense in the period of the product sale that benefits from the plan. Accounting: Company estimates the number of outstanding premium offers that customers will present for redemption. Company charges the cost of premium offers to Premium Expense and credits Estimated Liability for Premiums.

41 15-41 Premiums - Example Fluffy Cakemix Company offered its customers a large nonbreakable mixing bowl in exchange for 25 cents and 10 boxtops. The mixing bowl costs Fluffy Cakemix Company 75 cents, and the company estimates that customers will redeem 60 % of the boxtops. The premium offer began in June 2010 and resulted in the transactions journalized below. Fluffy Cakemix Company records purchase of 20,000 mixing bowls as follows. Inventory of Premium Mixing Bowls 15,000 Cash 15,000 $20,000 x.75 = $15,000

42 15-42 Premiums Example (cont d) The entry to record sales of 300,000 boxes of cake mix would be: 300,000 x.80 (given) = $240,000 Cash 240,000 Sales 240,000 Fluffy records the actual redemption of 60,000 boxtops (given), the receipt of 25 cents per 10 boxtops, and the delivery of the mixing bowls as follows. Cash [(60,000 / 10) x $0.25] 1,500 Premium Expense (( ) x 6,000) 3,000 Inventory of Premium Mixing Bowls 4,500 Cost Computation: (60,000 / 10) x $0.75 = $4,500

43 15-43 Premiums Example (cont d) Finally, Fluffy makes an end-of-period adjusting entry for estimated liability for outstanding premium offers (boxtops) as follows. Premium expense 6,000 Liability for premiums 6,000 Or, 120,000 = (300,000 x 60%) 60,000 redeemed

Current Liabilities and Contingencies

Current Liabilities and Contingencies Irsan Lubis - Dosen Perbanas Institute PREVIEW OF CHAPTER 13 13-1 Intermediate Accounting 15th Edition Kieso Weygandt Warfield 13 and Contingencies LEARNING OBJECTIVES After studying this chapter, you