Current Liabilities and Contingencies Chapter 13 Chapter 13: Current Liabilities and Contingencies. Chapter 13 deals with short-term liabilities. In Part A of the chapter, the focus is on liabilities that are classified appropriately as current. In Part B of the chapter, we turn our attention to situations in which there is uncertainty as to whether an obligation really exists. These are designated as loss contingencies. Some loss contingencies are accrued as liabilities, but others only are disclosed in the notes.

Characteristics of Liabilities A liability is a present obligation to sacrifice assets in the future because of something that already has occurred. Probable future sacrifices of economic benefits. Arise from present obligations to other entities. Result from past transactions or events. Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements. Liabilities have three essential characteristics. Liabilities:  Are probable, future sacrifices of economic benefits.  Arise from present obligations to transfer goods or provide services to other entities.  Result from past transactions or events. Characteristics of Liabilities: Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements. Some liabilities may not be payable in cash in future.

What is a Current Liability? LIABILITIES Current Liabilities Long-term Liabilities Obligations payable within one year or one operating cycle, whichever is longer. In a classified balance sheet, we categorize liabilities as either current liabilities or long-term liabilities. The general definition of a current liability is an obligation payable within one year or within the company’s operating cycle, whichever is longer. Another more discriminating definition identifies a current liability as an obligation expected to be satisfied with current assets or by the creation of other current liabilities. Liabilities should be recorded at their present values, but the relatively short-term maturity of current liabilities makes the time value component immaterial. Expected to be satisfied with current assets or by the creation of other current liabilities.

Short-term notes payable Cash dividends payable Current Liabilities Current Liabilities Short-term notes payable Accrued expenses Cash dividends payable Taxes payable Accounts payable Unearned revenues Examples of obligations reported as current liabilities are: Accounts payable. Taxes payable. Unearned revenues. Cash dividends payable. Accrued expenses. Short-term notes payable.

CURRENT LIABILITIES General Mills, Inc. Balance Sheet ($ in millions) May 29, 2011 and May 30, 2010 Assets [by classification] Liabilities Current Liabilities: 2011 2010 Accounts payable $ 995.1 $849.5 Current portion of long-term debt 1,031.3 107.3 Notes payable 311.3 1,050.1 Other current liabilities 1,321.5 1,769.1 Total current liabilities $3,659.2 $3,769.1 Long-term Liabilities: [listed individually] Shareholders’ equity [by source]

Salaries, Commissions, and Bonuses Compensation expenses such as salaries, commissions, and bonuses are liabilities at the balance sheet date if earned but unpaid. These accrued expenses/accrued liabilities are recorded with an adjusting entry prior to preparing financial statements. Compensation for employee services can be in the form of hourly wages, salary, commissions, bonuses, stock compensation plans, or pensions. Accrued liabilities arise in connection with compensation expense when employee services have been performed as of a financial statement date, but employees have yet to be paid. These accrued expenses/accrued liabilities are recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements.

Vacations, Sick Days, and Other Paid Future Absences An employer should accrue an expense and the related liability for employees’ compensation for future absences (such as vacation pay) if the obligation meets all four of these conditions: The obligation is for services already performed. The paid absence can be taken in a later year—the benefit vests or the benefit can be accumulated over time. Payment is probable. The amount can be reasonably estimated. An employer should accrue an expense and the related liability for employees’ compensation for future absences (such as vacation pay) if the obligation meets all four of these conditions: The obligation is attributable to employees’ services already performed. The paid absence can be taken in a later year—the benefit vests (will be compensated even if employment is terminated) or the benefit can be accumulated over time. Payment is probable. The amount can be reasonably estimated. The liability is accrued at the current wage rate. A liability for sick leave is normally not accrued because future absence depends on future illness, which usually is not a certainty. However, if employees are paid for unused sick days (such as at retirement) it’s appropriate to record a liability for the unused sick pay. Sick pay quite often meets the conditions for accrual, but accrual is not mandatory because future absence depends on future illness, which usually is not a certainty.

Exercise 13–4 Wages expense (increases wages expense to $410,000) 6,000 Liability—compensated future absences 6,000* * ($404,000 – 4,000] = $400,000 non-vacation wages x 1/40 = 10,000 vacation pay earned (4,000) vacation pay taken = $ 6,000 vacation pay carried over   Exercise 13–5 Requirement 1 Wages expense (700 x $900) 630,000 Liability—compensated future absences 630,000 Requirement 2 Liability—compensated future absences 630,000 Wages expense ($31 million + [5% x $630,000]) 31,031,500 Cash (or wages payable) (total) 31,661,500  

Liabilities from Advance Collections Refundable deposits Advances from customers Gift cards Collections for third parties Liabilities are created when amounts are received that will be returned or remitted to others. Examples are: Refundable deposits Advances from customers (called unearned revenue or deferred revenue) Gift cards (also unearned revenue) Collections for third parties

Customer Advance A customer advance produces an obligation that is satisfied when the product or service is provided.   Tomorrow Publications collects magazine subscriptions from customers at the time subscriptions are sold. Subscription revenue is recognized over the term of the subscription. Tomorrow collected $20 million in subscription sales during its first year of operations. At December 31, the average subscription was one-fourth expired. ($ in millions) When Advance is Collected Cash 20 Unearned subscriptions revenue 20 When Product is Delivered Unearned subscriptions revenue 5 Subscriptions revenue 5 Common example: Gift cards. Earn the revenue when either the gift card is used or the probability of redemption is viewed as remote.

Exercise 13–6: Customer Advances (Gift Cards) & Sales taxes Requirement 1 Cash 5,200 Liability—gift certificates 5,200 Cash ($2,100 + 84 – 1,300) 884 Liability—gift certificates 1,300 Sales revenue 2,100 Sales taxes payable (4% x $2,100) 84 Requirement 2 Gift certificates sold $5,200 Gift certificates redeemed (1,300) Liability to be reported at December 31 $3,900 Requirement 3 The sales tax liability is a current liability because it is payable in January. The liability for gift certificates is part current and part noncurrent: Gift certificates sold $5,200 x 80% Estimated current liability $4,160 Gift certificates redeemed (1,300) Current liability at December 31 $2,860 Noncurrent liability at December 31 ($5,200 x 20%) 1,040 Total $3,900

A Closer Look at the Current and Noncurrent Classification Current maturities of long-term obligations usually are reclassified and reported as current liabilities if they are payable within the upcoming year (or operating cycle, if longer than a year). Long-term obligations (bonds, notes, lease liabilities, deferred tax liabilities) usually are reclassified and reported as current liabilities when they become payable within the upcoming year (or operating cycle, if longer than a year). For example, a 20-year bond issue is reported as a long-term liability for 19 years but normally is reported as a current liability on the balance sheet prepared during the 20th year of its term to maturity. The requirement to classify currently maturing debt as a current liability includes debt that is callable (in other words, due on demand) by the creditor in the upcoming year (or operating cycle, if longer), even if the debt is not expected to be called. Debt that is callable by the lender in the coming year (or operating cycle, if longer) should be classified as a current liability, even if the debt is not expected to be called.

Note Issued for Cash Interest Bearing Notes:   Interest Bearing Notes: Face amount x Annual rate x Time to maturity On May 1, Affiliated Technologies, Inc., a consumer electronics firm, borrowed $700,000 cash from First BancCorp under a noncommitted short-term line of credit arrangement and issued a 6-month, 12% promissory note. Interest was payable at maturity. May 1 Cash 700,000 Notes payable 700,000 November 1 Interest expense ($700,000 x 12% x 6/12) 42,000 Notes payable 700,000 Cash ($700,000 + 42,000) 742,000

Noninterest-Bearing Note The proceeds of the note are reduced by the interest in a “noninterest-bearing” note. Situation: $700,000 noninterest-bearing note, with a 12% “discount rate.” The $42,000 interest is “discounted” at the outset, rather than explicitly stated:   May 1 Cash (difference) 658,000 Discount on notes ($700,000 x 12% x 6/12) 42,000 Notes payable (face amount) 700,000 November 1 Interest expense 42,000 Discount on notes 42,000 Notes payable (face amount) 700,000 Cash 700,000 EFFECTIVE INTEREST RATE The amount borrowed is only $658,000, but the interest is calculated as the discount rate times the $700,000 face amount. This causes the effective interest rate to be higher than the 12% stated rate: $ 42,000 interest for 6 months ÷ $658,000 amount borrowed = 6.38% rate for 6 months x 12/6 to annualize the rate = 12.76% effective interest rate

ACCRUED LIABILITIES    Liabilities accrue for expenses that are incurred, but not yet paid.  Recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements.  Common examples are: salaries and wages payable, income taxes payable, and interest payable.

ACCRUED INTEREST PAYABLE On May 1, Affiliated Technologies, Inc., a consumer electronics firm, borrowed $700,000 cash from First Banc Corp under a non-committed short-term line of credit arrangement and issued a 6-month, 12% promissory note. Interest was payable at maturity. The fiscal period for Affiliated Technologies ends on June 30, two months after the 6-month note is issued. The issuance of the note, intervening adjusting entry, and note payment would be recorded as shown below: Issuance of note May 1 Cash 700,000 Note payable 700,000 Accrual of interest on June 30 Interest expense ($700,000 x 12% x 2/12) 14,000 Interest payable 14,000 Note payment November 1 Interest expense ($700,000 x 12% x 4/12) 28,000 Interest payable (from adjusting entry) 14,000 Note payable 700,000 Cash ($700,000 + 42,000) 742,000

Short-Term Obligations Expected to be Refinanced A company 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. It has demonstrated the ability to refinance. and 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. A company may reclassify a short-term liability as long-term only if two conditions are met: It has the intent to refinance on a long-term basis. 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.

INTERNATIONAL FINANCIAL REPORTING STANDARDS   Classification of Liabilities to be Refinanced. Under U.S. GAAP, liabilities payable within the coming year are classified as long-term liabilities if refinancing is completed before date of issuance of the financial statements. Under IFRS, refinancing must be completed before the balance sheet date.

Exercise 13–11 Normally, short-term debt (payable within a year) is classified as current liabilities. However, when such debt is to be refinanced on a long-term basis, it should be included with long-term liabilities. The narrative indicates that Sprint has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis. Thus, Sprint reported the debt as long-term liabilities. Exercise 13–12 Requirement 1 Normally, IFRS requires that short-term debt (payable within a year) be classified as current liabilities. However, when such debt is to be refinanced on a long-term basis, it may be included with long-term liabilities. The narrative indicates that Sprint has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis. Thus, Sprint reported the debt as long-term liabilities. Requirement 2 IFRS requires that the refinancing capability be in place as of the balance sheet date. Therefore, given that the refinancing was not arranged until after year-end, IFRS would require that the debt be classified as a current liability.

Exercise 13

Loss Contingencies A loss contingency is an existing uncertain situation involving potential loss depending on whether some future event occurs. Two factors affect whether a loss contingency must be accrued and reported as a liability: The likelihood (probability) that the confirming event will occur. Whether the loss amount can be reasonably estimated. A loss contingency is an existing uncertain situation involving potential loss depending on whether some future event occurs. Two factors affect whether a loss contingency must be accrued and reported as a liability:  The likelihood that the confirming event will occur.  Whether the loss amount can be reasonably estimated.

Loss Contingencies The table on this screen summarizes the accounting and reporting for loss contingencies. The information presented here should provide you with a quick reference and a very useful study guide for loss contingencies. In summary, a loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated. A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated. Exercise 13-17 Brief Exercises 13, 14, 15, 16

IFRS defines “probable” as “more likely than not” (greater than 50%), which is a lower threshold than typically associated with “probable” in U.S. GAAP. If a liability is accrued, IFRS measures the liability as the best estimate of the expenditure required to settle the present obligation. If there is a range of equally likely outcomes, IFRS would use the midpoint of the range, while U.S. GAAP requires use of the low end of the range. Brief Exercises 17

Product Warranties and Guarantees Product warranties inevitably entail costs. The amount of those costs can be reasonably estimated using commonly available estimation techniques. The estimate requires the following entry: Warranty expense ......................................... $,$$$ Estimated warranty liability .............. $,$$$ To accrue warranty expense. Product warranties inevitably entail costs. Since the amounts of those future costs can be reasonably estimated, usually based on past experience, we should accrue a liability for the estimated cost of the warranty obligation. To accrue the warranty liability, we debit warranty expense and credit estimated warranty liability. This entry is recorded in the period of the sale of the items under warranty in order to match the future warranty expense to the revenues earned. Exercise 13-15, Brief Exercise 12

Extended Warranty Contracts Extended warranties are sold separately from the product. The related revenue is not earned until: Claims are made against the extended warranty, or The extended warranty period expires. Extended warranties are sold separately from the product. Even though cash is received at the time the warranty contract is sold, revenue is not recognized until it is earned. At the time of the sale, an entry is made to record a liability for the deferred revenue. In most cases, the deferred revenue (liability) is recognized as revenue on a straight-line basis over the life of the extended warranty. Exercise 13-16

Premiums Premiums included with the product are expensed in the period of sale. Premiums that are contingent on action by the customer require accounting similar to warranties. Exercise 13-19 Premiums are promotional items provided with a product to enhance the sale of the product. Premiums included with the product are expensed in the period of sale. Premiums that are contingent on action by the customer require accounting similar to warranties. Mail-in, cash rebate offers are an example of the second type of premium. The cost of the cash rebates, based on estimated redemptions, using past redemption history, is recognized as an expense in the period of sale, and as an estimated liability. While it is difficult to predict whether a particular buyer will redeem a premium, it is much easier to predict the total number of premiums that will be redeemed based on how previous customers have tended to react.

The most common disclosure is a note to the financial statements. Litigation Claims The majority of medium- and large-size corporations annually report loss contingencies due to litigation. The most common disclosure is a note to the financial statements. The majority of medium- and large-size corporations annually report loss contingencies due to litigation. The most common disclosure is a note to the financial statements. Accrual of a loss due to pending or actual litigation is extremely rare. Most companies realize that the outcome of litigation is highly uncertain, making likelihood predictions difficult. Companies may accrue estimated lawyer fees and other legal costs, but usually do not record a loss until after the ultimate settlement has been reached or negotiations for settlement are substantially completed. Instead, disclosure notes typically describe the specifics of the litigation along with whether management feels an adverse outcome would materially affect the financial position of the company.

Subsequent Events Events occurring between the fiscal year-end date and report date can affect the appearance of disclosures on the financial statements. Cause of Loss Contingency Clarification Events occurring between a company’s fiscal year‐end date and the financial statement issue date are called subsequent events. These subsequent events can be used to determine how contingencies, existing before the fiscal year‐end, are reported. Fiscal Year Ends Financial Statements

Subsequent Events Events occurring after the year-end date but before the financial statements can also affect the appearance of disclosures on the financial statements. Cause of Loss Contingency Clarification If a contingency occurs after the fiscal year‐end date, a liability cannot be accrued because it didn’t exist at the end of the year. However, if failure to disclose any possible loss would result in misleading financial statements, the situation should be described in a disclosure note, including the effect of any possible loss on key accounting numbers. In fact, any event occurring after the fiscal year-end but before the financial statements are issued that has a material effect on the company’s financial position must be disclosed in a subsequent events disclosure note. Examples are an issuance of debt or equity securities, a business combination, and discontinued operations. Fiscal Year Ends Financial Statements

Unasserted Claims and Assessments  Is a claim or assessment probable? No disclosure needed No An unfiled lawsuit or an unasserted claim or assessment need not be disclosed unless it is probable that the claim or assessment will occur. If it is probable, then the likelihood of an unfavorable outcome and the feasibility of estimating a dollar amount should be considered in deciding whether and how to report the probable loss. A two-step process is involved in deciding how an unasserted claim should be reported: 1. Is a claim or assessment probable? (If the answer to this question is no, no disclosure is needed; skip step 2.) 2. Only if a claim or assessment is probable should we evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated. If the conclusion of step 1 is that the claim or assessment is not probable, no further action is required. If the conclusion of step 1 is that the claim or assessment is probable, the decision as to whether or not a liability is accrued or disclosed is precisely the same as when the claim or assessment already has been asserted. Yes Evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated. An estimated loss and contingent liability would be accrued if an unfavorable outcome is probable and the amount can be reasonably estimated.

As a general rule, we never record GAIN contingencies. Note that the prior rules have supported the recording of LOSS contingencies. As a general rule, we never record GAIN contingencies. A gain contingency is an uncertain situation that might result in a gain. Although loss contingencies are accrued when certain conditions are met, gain contingencies are not accrued. The practice of conservatism accounts for the difference in treatment of loss contingencies and gain contingencies. Even though gain contingencies are not accrued, those that are material may be disclosed in notes to the financial statements. When disclosing gain contingencies, the wording should not be so optimistic as to give misleading implications as to the likelihood of realization.

End of Chapter 13 End of Chapter 13.