Chapter 10: Current Liabilities and Contingencies 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.”

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

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.

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 taxes 7. Income taxes payable (App 10B) 8. Payroll taxes

Determinable CL - continued 9. 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

Contingent Liabilities Contingent on some future event or activity in order to know the exact amount. Examples: warranties, coupons and lawsuits Current Examples? Changes in estimate may be made in subsequent periods, when future event is concluded.

Figure 10-5

Contingent Liabilities - continued 1. Warranties Uncertain future costs Record estimated expense and liability when products are sold (matching concept): Warranty Expense xx Estimated Warranty Liability xx As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Cash, etc. xx

Contingent Liabilities - continued 2. Coupons and Premiums Record estimated expense and liability when products are sold (matching concept): Promotion Expense xx Estimated Coupon Liability xx As costs are incurred, as coupons or promotional offerings are redeemed (usually in subsequent periods), charge expenditure to liability: Cash, etc. xx

Contingent Liabilities - continued 3. Lawsuits If contingency should be accrued: Estimated Loss on Lawsuit xx Estimated Liability xx (and disclose information regarding case)

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.

Class Problem: P10-4, Part c: Adjusting journal entry for 2008: Estimated loss 742,000 Estimated liability 742,000 (Best guess in the range) Journal entry at settlement (8/12/09): Estimated liability 742,000 Recovery of estimated loss 52,000 Cash 690,000

Warranty A promise by a manufacturer or seller to ensure the quality or performance of the product for a specific period of time I’ll stand behind it for 50 miles or 50 minutes whichever comes first Almost Honest JOHN’S Used Cars 13

Class Exercise: E10-10(a) (1) GJE to record sale in 2008 (200 @ $250 each): Cash 50,000 Sales revenue 50,000 (2) AJE in 2008 to record estimated warranty for the sales (200 @ $20): Warranty expense 4,000 Estimated Warr. Liability 4,000 (3) GJE to record payment in 2008 for repairs: Est. Warr. Liability 1,400 Cash 1,400 GJE to record payment in 2009 for repairs: Est. Warr. Liability 2,600 Cash 2,600

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 2008 2009 2008 2009 Revenues 50,000 --- 50,000 --- 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.

Deferred Taxes Journal entry for historical treatment: I. T. Expense xx net income x % DIT (debit or credit) xx / xx plug I. T. Payable xx tax income x % Problems: after many years, the difference, primarily due to things like depreciation, had become one of the larger liabilities on the balance sheet. in some cases, the liability was greater than anything else in the balance sheet. Solution (in SFAS 109): prepare a detailed schedule to calculate the amount for IT Payable and DIT, and let IT Expense be the plug.

SFAS 109 Journal entry for SFAS 109: I. T. Expense xx plug DIT xx / xx schedule I. T. Payable xx schedule Before developing the schedule, we first need to discuss what items need to go into the schedule. Permanent differences (like income on municipal bonds) are excluded from the DIT schedule. Only temporary differences are included in the schedule. Temporary differences fall into two categories: those differences that lead to lower taxable income at the time of origination (future taxable). those differences that lead to higher taxable income at the time of origination (future deductible).

SFAS 109 - Future Taxable Items Future taxable (FT) items are amounts that are taxable in the future, because they are not taxable now. They include: Revenues or gains that are recognized in taxable income after they are recognized in financial income (such as income from equity investments in excess of dividends received). Expenses or losses that are recognized in taxable income before they are recognized in financial income (such as MACRS depreciation used for taxable income, while straight-line depreciation used for financial income.)

SFAS 109 - Future Deductible Items Future deductible (FD) items are amounts that lead to more tax now, but less tax in the future They include: Revenues or gains that are recognized in taxable income before they are recognized in financial income (such as cash received in advance for future services). Expenses or losses that are recognized in taxable income after they are recognized in financial income (this includes most estimates, such as bad debt expense, warranty expense loss contingencies, and pension expense in excess of cash paid).

Illustration of Schedule in First Year Assume a 30% tax rate for current and future years. Current year Future years I. T. Payable Deferred I.T. Pretax financial income $100,000 Future taxable: Exp: excess MACRS depr. (1,000) 1,000 Taxable income Deferred amount Tax rate .30 .30 Income tax payable Deferred tax liability Journal entry (income tax expense is the plug): $ 99,000 1,000 $29,700 $300 Income tax expense 30,000 Income tax payable 29,700 Deferred tax liability 300

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