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Chapter 10 Introduction to Liabilities: Economic Consequences, Current Liabilities and Contingencies 2
Liabilities What is a liability? FASB - 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
The Relative Size of Liabilities on the Balance Sheet Figure 10-1 Liabilities as a percentage of total assets 4
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 When and how to borrow money are important decisions 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
Current Liabilities Figure 10-2 Current liabilities as a percentage of total liabilities 6
Current Liabilities 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. 7
Determinable / Contingent Liabilities Figure 10-3 Outline of current liabilities 8
Determinable Current Liabilities Accounts payable Short-term debts Short-term notes Current maturities of long-term debts Dividends payable Unearned revenues Third Party Collection Income taxes The dollar value of these liabilities is relatively straight forward hence determinable Incentive compensation 9
Determinable Current Liabilities 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
Incentive Compensation Figure 10-4 Bonus formulas of selected large corporations for executive compensatio n pools 11
Contingencies and 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, many 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
Loss Contingencies Figure 10-5 Accounting for contingencies 13
Warranty A promise by a manufacturer or seller to ensure the quality or performance of the product for a specific period of time 14
Contingent Liabilities Warranties Uncertain future costs Record estimated expense and liability when products are sold (matching concept): Warranty Expense xx Contingent Warranty Liability xx As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Contingent Warranty Liability xx Cash xx 15
Class Problem: P10-4, Parts a & b: Issues and recommendations: - Likelihood? Probable - Disclose? Yes - Disclosure? Indicate range and level of probability (250,000 1.5 million) - Accrue? Since probable (or greater) and estimable, accrual is required, based on best estimate. 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 17
Class Exercise: E10-10(a) (1) GJE to record sale in 2014 (200 @ $250 each): Cash 50,000 Sales revenue 50,000 (2) AJE in 2014 to record estimated warranty for the sales (200 @ $20): Warranty expense 4,000 Contingent Warranty Liability 4,000 (3) GJE to record payment in 2014 for repairs: Contingent Warranty Liability 1,400 Cash 1,400 GJE to record payment in 2015 for repairs: Contingent Warranty Liability 2,600 Cash 2,600 18
Class Exercise: E10-10(b) Income effects for the revenue and warranty expense under the two alternative for recognition of expense : Accrue Expense Expense as Paid 2011 2012 2011 2012 Revenues 50,000 --- 50,000 --- Warr. Expense (4,000) --- (1,400) (2,600) Note: the accrual method recognizes the expense in the same period as the revenues generated by the sale. 19
Appendix 10A Retirement Costs: Pensions and Postretirement Healthcare and Insurance 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 20
Cont d Appendix 10A Retirement Costs 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 The entry to record periodic payment Dr. Pension Liability Cr. Cash 21
Cont d Appendix 10A Retirement Costs Postretirement Healthcare and Insurance Costs Most large companies provide some after retirement expenses for healthcare and insurance. These items must be estimated and expensed over the employees time of service. These entries are similar to pension entries. 22
Appendix B - Deferred Income Taxes Generated by the discrepancy between income and expenses for taxation (specified by IRS) and financial reporting (specified by GAAP). - Example: Equipment purchased on 1/1/12 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% 23
App B - The Concept of Deferred Income Taxes Year DDB SL Diff Rate Tax Benefit (Disbenefit) 2012 $6000-3000 = $3000 X 30% = $900 2013 2000-3000 = (1000) X 30% = (300) 2014 1000-3000 = (2000) X 30% = (600) Total $9000 $9000 $0 $0 Figure 10B-1 Income tax effects due to DDB depreciation 2012 Deferred income tax liability $900 2013 Deferred income tax benefit $300 2014 Deferred income tax benefit $600 24
App B - Deferred Income Taxes: Additional Issues Figure 10B-3 Deferred income tax liability (selected U.S. companies) 25
Appendix B - The Conservatism Ratio Knowing that companies defer taxable income, a measure around 1.0 or less indicates relative conservatism. Reported income is increasingly less conservative at ratios greater than 1.0. Figure 10B-4 Conservatis m Ratios Conservatism Ratio: Reported Income before Taxes/Taxable Income 26
Appendix B - The Conservatism Ratio Figure 10B-5 The conservatism ratio of General Electric (dollars in millions) 27
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