Chapter 10. Introduction to Liabilities: Economic Consequences, Current Liabilities and Contingencies

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2 Chapter 10 Introduction to Liabilities: Economic Consequences, Current Liabilities and Contingencies 2

3 Liabilities 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. 3

4 Liabilities 4

5 Reporting Liabilities on the Balance Sheet: Economic Consequences Shareholders 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 5

6 Current Liabilities 6

7 Classification Current Liabilities 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. 7

8 Figure

9 Determinable Current Liabilities 1. Accounts payable (Ch 7) 2. Short-term notes 3. Current maturities of long-term debts 4. Dividends payable 5. Unearned revenues (Ch 5) 6. Sales tax payable 7. Income taxes payable (App 10B) 8. Payroll taxes payable 9

10 Determinable CL - continued 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 10

11 Incentive Compensation 11

12 Contingent Liabilities Contingent on some future event or activity in order to know the exact amount. Examples: warranties, coupons and lawsuits Changes in estimate may be made in subsequent periods, when future event is concluded. Under IFRS, much of these transactions are reported in a balance sheet account called provisions. Provisions are more readily booked than contingent liabilities because IFRS provisions are accrued when the obligation is more likely than not, while under US GAAP contingent liabilities are accrued when highly probable, which is a much higher threshold. 12

13 Figure

14 Contingent Liabilities Warranties Uncertain future costs Record estimated expense and liability when products are sold (matching concept): Warranty Expense Estimated Warranty Liability xx xx As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Estimated Warranty Liability Cash, etc. xx xx 14

15 Class Problem: P10-4, Parts a & b: Issues and recommendations: - Likelihood? Probable - Disclose? Yes - Disclosure? Indicate range and level of probability (250, million) - Accrue? Since probable (or greater) and estimable, accrual is required, based on best estimate. 15

16 Class Problem: P10-4, Part c: Adjusting journal entry for 2011: Estimated loss 742,000 Estimated liability 742,000 (Best guess in the range) Journal entry at settlement (8/12/12): Estimated liability 742,000 Recovery of estimated loss 52,000 Cash 690,000 16

17 Warranty A promise by a manufacturer or seller to ensure the quality or performance of the product for a specific period of time Almost Honest JOHN S I ll stand behind it for 50 miles or 50 minutes whichever comes first Used Cars 17

18 Class Exercise: E10-10(a) (1) GJE to record sale in 2011 $250 each): Cash 50,000 Sales revenue 50,000 (2) AJE in 2011 to record estimated warranty for the sales $20): Warranty expense 4,000 Estimated Warr. Liability 4,000 (3) GJE to record payment in 2011 for repairs: Est. Warr. Liability 1,400 Cash 1,400 GJE to record payment in 2012 for repairs: Est. Warr. Liability 2,600 Cash 2,600 18

19 Class Exercise: E10-10(b) Income effects for the revenue and warranty expense under the two alternative for recognition of expense (expressed in thousands): Accrue Expense Expense as Paid Revenues 50, , 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. 19

20 Retirement Costs (App 10A) Defined Contribution Plans Less expensive than Defined Benefit Plans 401(k), 403(b), 457 The entry to record period contributions is very simple: Dr. Pension Expense Cr. Cash Defined Benefit Plans Benefits must be predicted, therefore several assumptions and estimates are required Social Security is form of Defined Benefit Plan The entry to record the estimated liability is simple, but the calculations can be quite complicated: Dr. Pension Expense Cr. Pension Liability 20

21 Deferred Taxes (App 10B) Generated by the discrepancy between income and expenses for taxation (specified by IRS) and financial reporting (specified by GAAP). Example: Equipment purchased on 1/1/09 for $9,000 3-year useful life no salvage value DDB for income tax purposes SL for financial reporting purposes Income tax rate of 30% 21

22 Depreciation Schedules Year DDB SL Diff Rate Tax Benefit (Disbenefit) 2009 $ = $3000 X 30% = $ = (1000) X 30% = (300) = (2000) X 30% = (600) Total $9000 $9000 $0 $ Deferred income tax liability $ Deferred income tax benefit $ Deferred income tax benefit $600 22

23 Deferred Income Tax Liability 23

24 The Conservatism Ratio 24

25 The Conservatism Ratio 25

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