Chapter Twelve. Current Liabilities. Current Liabilities for Competing Companies

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1 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 1 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 2 Current Liabilities for Competing Companies Ford Motor General Motors #4 in Fortune 500 #3 in Fortune 500 Dec Dec 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. 3 1

2 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 Critical Thinking Discussion: What is the impact on the balance sheet of accruing an expense that has been incurred but not yet paid? 5 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 At year end, record amount earned: Deferred Revenue xxx Income xxx xxx 6 2

3 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. 7 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 8 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. 9 3

4 Calculating Vacation Pay Accruals Assume that Nichols Co. has 50 employees during 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, Calculating Vacation Pay Accruals Ten employees use all vacation days in When they are paid their vacation pay, record this entry: Vacation Payable (10 x 10 x $100) 10,000 Cash 10, 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,

5 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. 13 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 intent and ability to refinance are present. 14 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. 15 5

6 Contingencies An existing situation, condition, or set of circumstances involving uncertainty that will be resolved when one or more future events occur 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. 16 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 17 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? 18 6

7 Loss Contingencies Existing circumstances involving a potential loss that 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. 19 Critical Thinking Discussion: Why do you think companies are reluctant to accrue contingent liabilities? 20 Disclosure of Loss Contingencies If contingency is probable If contingency is reasonably possible Accrue as a liability, disclose details in notes to financials Do not accrue as a liability, but disclose in notes to the financials If contingency is remote Do not accrue as a liability or disclose in notes 21 7

8 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? 22 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 23 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. 24 8

9 Warranty Liabilities Illustrated Illustration: Assume that Tesla Co. sells 100 cars for $60,000 each during 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, 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, 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,

10 Cash Warranty Liabilities At year end $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, 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 Estimated Liability for Coupons xxx xxx 29 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 30 10

11 Liquidity Analysis and Current Liabilities Current Ratio = Working Capital = Total Assets Total Liabilities 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 31 Liquidity Analysis and Current Liabilities Working Capital = Total Assets Total Liabilities Identifies the amount of current assets available to continue business operations Current Ratio = Current Assets Current Liabilities Identifies how well a company is able to meet its current obligations 32 Cash Flow and Current Liabilities Most current liabilities are related to operating activities When determining actual cash flows for current liabilities, examine the balances of all current liability accounts 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 33 11

12 Check Your Understanding Q What journal entry is generally made when cash is received in advance but has not yet been earned? 34 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? 35 Check Your Understanding Q How would an increase in a current liability account be treated on the statement of cash flows using the indirect method? 36 12

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