1. CURRENT LIABILITIES AND CONTINGENCIES Chapter 13 © 2013 The McGraw-Hill Companies, Inc.

2. Slide 2 Characteristics of Liabilities... Result in an out flow of resources in the future.... Arising from past events... Present Obligation... © 2013 The McGraw-Hill Companies, Inc.

3. Slide 3 What is a Current Liability? LIABILITIES Long-term Liabilities Other situations: For trading purposes, or does not have the right to defer settlement for at least 12 months Other situations: For trading purposes, or does not have the right to defer settlement for at least 12 months Current Liabilities Obligations payable within one year or one operating cycle, whichever is longer. © 2013 The McGraw-Hill Companies, Inc.

4. Slide 4 Current Liabilities Short-term notes payable Accrued expenses Cash dividends payable Taxes payable Accounts payable Unearned revenues © 2013 The McGraw-Hill Companies, Inc.

5. Slide 5 Open Accounts and Notes Accounts Payable Obligations to suppliers for goods purchased on open account. Trade Notes Payable Similar to accounts payable, but recognized by a written promissory note. Short-term Notes Payable Cash borrowed from the bank and recognized by a promissory note. Credit lines Prearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork. Accounts Payable Obligations to suppliers for goods purchased on open account. Trade Notes Payable Similar to accounts payable, but recognized by a written promissory note. Short-term Notes Payable Cash borrowed from the bank and recognized by a promissory note. Credit lines Prearranged agreements with a bank that allow a company to borrow cash without following normal loan procedures and paperwork. © 2013 The McGraw-Hill Companies, Inc.

6. Slide 6 Interest Interest on notes is calculated as follows: Amount borrowed Interest rate is always stated as an annual rate. Interest owed is adjusted for the portion of the year that the face amount is outstanding. © 2013 The McGraw-Hill Companies, Inc.

7. Slide 7 Interest-Bearing Notes On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 6 months and has a stated interest rate of 9%. Record the borrowing on September 1. On September 1, Eagle Boats borrows $80,000 from Cooke Bank. The note is due in 6 months and has a stated interest rate of 9%. Record the borrowing on September 1. © 2013 The McGraw-Hill Companies, Inc.

8. Slide 8 How much interest is due to Cooke Bank at year-end, on December 31? a.$2,400 b.$3,600 c.$7,200 d.$87,200 How much interest is due to Cooke Bank at year-end, on December 31? a.$2,400 b.$3,600 c.$7,200 d.$87,200 Interest-Bearing Notes Interest is calculated as: Principal Annual Time to Amount Rate maturity $80,000 9% 4/12 $2,400 interest due to Cooke Bank. Interest is calculated as: Principal Annual Time to Amount Rate maturity $80,000 9% 4/12 $2,400 interest due to Cooke Bank. ×× ×× = = © 2013 The McGraw-Hill Companies, Inc.

9. Slide 9 Interest-Bearing Notes Assume Eagle Boats’ year-end is December 31. Record the necessary adjustment at year-end. Assume Eagle Boats’ year-end is December 31. Record the necessary adjustment at year-end. © 2013 The McGraw-Hill Companies, Inc.

10. Slide 10 Interest-bearing Notes Assume Eagle Boats’ year-end is December 31. Record the necessary journal entry when the note matures on February 28. Assume Eagle Boats’ year-end is December 31. Record the necessary journal entry when the note matures on February 28. © 2013 The McGraw-Hill Companies, Inc.

11. Slide 11 Noninterest-Bearing Notes Notes without a stated interest rate carry an implicit, or effective rate. The principal of the note includes the amount borrowed and the interest. Notes without a stated interest rate carry an implicit, or effective rate. The principal of the note includes the amount borrowed and the interest. © 2013 The McGraw-Hill Companies, Inc.

12. Slide 12 On May 1, Batter-Up Ltd. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. How much interest will Batter-Up pay on the note? On May 1, Batter-Up Ltd. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. How much interest will Batter-Up pay on the note? Interest = Face Amount - Amount Borrowed = $10,600 - $10,000 = $600 Interest = Face Amount - Amount Borrowed = $10,600 - $10,000 = $600 Noninterest-Bearing Notes © 2013 The McGraw-Hill Companies, Inc.

13. Slide 13 Noninterest-Bearing Notes On May 1, Batter-Up Ltd. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. What is the effective interest rate on the note? On May 1, Batter-Up Ltd. issued a one-year, noninterest-bearing note with a face amount of $10,600 in exchange for equipment valued at $10,000. What is the effective interest rate on the note? © 2013 The McGraw-Hill Companies, Inc.

14. Slide 14 Commercial Paper Commercial paper is a term used for unsecured notes issued in minimum denominations of say $25,000 with maturities usually ranging from 30 days to 270 days. Normally, commercial paper is issued directly to the lender and is backed by a line of credit with a bank. Commercial paper is recorded in the same manner as notes payable. © 2013 The McGraw-Hill Companies, Inc.

15. Slide 15 Salaries, Commissions, and Bonuses Compensation expenses such as salaries, commissions, and bonuses are liabilities at the financial reporting date if earned but unpaid. These accrued expenses/accrued liabilities are recorded with an adjusting entry prior to preparing financial statements. © 2013 The McGraw-Hill Companies, Inc.

16. Slide 16 Compensated absences Accumulated compensated absences Non-accumulating compensated absences Current and past leave entitlement can be used in future periods. Unused leave expires and are not carried forward to a future period Recognize expected cost of employee benefits in the same period when the employee renders service Recognizes expense on paid leave only when the leave is utilized Accrue an expense and liability for accumulated compensated absence because: Past Event: Employees has performed the services required to earn the leave Existing obligation: Employers have an existing obligation to allow employees to take their unused leave in future periods or to pay for unused leave Future outflow of benefits: The paid absence can be taken in a future period or there is a monetary payment for leave that is unused © 2013 The McGraw-Hill Companies, Inc.

17. Slide 17 Liabilities from Advance Collections Deposits (Refundable or Non- Refundable) Advances from Customers Collections for Third Parties Deposits (Refundable or Non- Refundable) Advances from Customers Collections for Third Parties Past Event Creates Current Obligation Firm Transfers Resources or Performs Services in future © 2013 The McGraw-Hill Companies, Inc.

18. Slide 18 A Closer Look at the Current and Noncurrent Classification The classification of financial liabilities requires the consideration of The terms of contract including the date of settlement, The right of the creditor to call back the loan, The right of the borrower to reschedule the loan repayment, and The provision of a grace period in the event that the borrower breaches a covenant in the debt agreement etc. © 2013 The McGraw-Hill Companies, Inc.

19. Slide 19 A Closer Look at the Current and Noncurrent Classification Current maturities of long-term obligations are usually reclassified and reported as current liabilities if they are payable within the upcoming year (or operating cycle, if longer than a year). Debt that is callable (due on demand) by the lender in the coming year, (or operating cycle, if longer than a year) should be classified as a current liability, even if the debt is not expected to be called. © 2013 The McGraw-Hill Companies, Inc.

20. Slide 20 A Closer Look at the Current and Noncurrent Classification Conversely, even if the obligation is due within a shorter period, the long-term classification applies if the borrowing entity expects and has the discretion to refinance or roll over an obligation for at least 12 months after the reporting period. If the debt becomes callable due to a default (i.e. by violation of contract covenant), and the creditor extends a grace period, the long-term classification would still apply if the following conditions are met The lender agrees to the grace period on or before the end of the reporting period The grace period ends at least twelve months after the reporting period, during which the lender cannot demand immediate repayment It is probable that the borrower can make rectification of the violation within the extended grace period © 2013 The McGraw-Hill Companies, Inc.

21. Slide 21 Short-Term Obligations Expected to be Refinanced 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. and © 2013 The McGraw-Hill Companies, Inc. The ability to refinance is an unconditional right at the financial year-end granted by the lender to defer settlement for at least twelve months. And it can be demonstrated by an:  existing refinancing agreement, or  actual refinancing at the financial year-end

22. Slide 22 Short-Term Obligations Expected to be Refinanced Form of Refinancing The specific form of the long-term refinancing is irrelevant when determining the appropriate classification – however the arrangement must be with the lender Events after Year End Under IFRS, events (i.e. refinancing) occurring after the financial year end, but before the financial statements are issued, can be used to clarify the nature of financial statement elements at the reporting date There are discussions between IASB and FASB to change the definition of “short term” to mean “within one year”, regardless of the length of the reporting period. © 2013 The McGraw-Hill Companies, Inc.

23. Slide 23 Contingent Liabilities A contingent liability is recorded for (1) a possible obligation; or (2) a present obligation with future outflows that are not probable or cannot be reliably measured. The uncertainties relate to: 1. The existence of the obligation or 2. The probability/amount of outflow The uncertainties relate to: 1. The existence of the obligation or 2. The probability/amount of outflow © 2013 The McGraw-Hill Companies, Inc.

24. Slide 24 Contingencies A contingent liability is never accrued, but is only disclosed in the footnotes to the financial statements: 1. The reporting entity must: Describe the nature of the contingent liability, and Provide an estimate of the financial effect, 2. And if practicable Indicate the uncertainties relating to the amount and timing of the outflows, and State the possibility of any reimbursement. 3. Note that the cause of the uncertainty must occur before the financial statement date. A contingent liability is never accrued, but is only disclosed in the footnotes to the financial statements: 1. The reporting entity must: Describe the nature of the contingent liability, and Provide an estimate of the financial effect, 2. And if practicable Indicate the uncertainties relating to the amount and timing of the outflows, and State the possibility of any reimbursement. 3. Note that the cause of the uncertainty must occur before the financial statement date. © 2013 The McGraw-Hill Companies, Inc.

25. Slide 25 Provisions A provision is a liability as it has all the three characteristics of a one. (1) past obligating event has occurred (2) present obligation that leads to a (3) future outflow of benefits. A provision is a liability as it has all the three characteristics of a one. (1) past obligating event has occurred (2) present obligation that leads to a (3) future outflow of benefits. The only uncertainties are: Timing, and Amount of the future outflow of benefits Different from a contingent liability No uncertainty in the existence of the obligation There is a probable outflow © 2013 The McGraw-Hill Companies, Inc.

26. Slide 26 Provisions Provisions are not “off balance sheet” They are recognized if the three conditions below are met An entity has present obligation that arises as a result of a past event It is probable that an outflow of resources will be required the settle the obligation A reliable estimate can be made of the amount of the obligation Present Obligation Can be either legal or contractual Legal obligations arise from contracts or laws Constructive obligations arise from “valid expectations” that arise from an entity’s actions and representations For a contractual or legal obligation to exist, an obligating event must have occurred © 2013 The McGraw-Hill Companies, Inc.

27. Slide 27 Provisions Probable outflow Probable” in IAS 37 means “more likely than not” “More likely than not” is not explicitly defined, but.. May assume a lower probability threshold than what is implied by the term “probable”. Reliable estimate “Best estimate of the expenditure to settle the present obligation at the end of the reporting period.” Which is the also the “amount that an entity would rationally pay to settle or transfer” An exception to this test is deemed to be extremely rare Discounting required if the time value is material An Expected Value Approach may be used when there is (1) a large population of items or, (2) a large number of possible outcomes. © 2013 The McGraw-Hill Companies, Inc.

28. Slide 28 Onerous Contracts An onerous contract is one in which: “the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.“ Unavoidable cost = The lower of the cost fulfilling of fulfill a contract, and any compensation or penalties arising from failure to fulfill it.” When a contract becomes onerous: An impairment loss on assets dedicated to that contract should be recognized under IAS No. 36 The “Unavoidable cost” is the least net cost of exiting from the contract Then, the present obligations under the contract should be recognized and measured as a provision NOTE: Executory Contracts Normally “off balance sheet” Recognize a liability under IAS No. 37 when onerous © 2013 The McGraw-Hill Companies, Inc.

29. Slide 29 Product Warranties Product warranties inevitably entail costs. Like other provisions, the amount of those costs can be reasonably estimated using commonly available estimation techniques. The estimate requires the following entry: Product warranties inevitably entail costs. Like other provisions, the amount of those costs can be reasonably estimated using commonly available estimation techniques. The estimate requires the following entry: © 2013 The McGraw-Hill Companies, Inc.

30. Slide 30 Extended Warranties 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 (normally recognized on a straight-line basis over the period). 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 (normally recognized on a straight-line basis over the period). © 2013 The McGraw-Hill Companies, Inc.

31. Slide 31 Litigation Claims The majority of medium and large-size corporations annually report contingent liabilities due to litigation. The most common disclosure is a note to the financial statements. The majority of medium and large-size corporations annually report contingent liabilities due to litigation. The most common disclosure is a note to the financial statements. © 2013 The McGraw-Hill Companies, Inc.

32. Slide 32 Subsequent Events When the cause of a loss contingency occurs before the year-end, an adjusting event before financial statements are issued can be used to determine how the contingency is reported. Adjusting Events Occur in the period between the end of a company’s financial year and the financial statements authorization date Provide evidence of conditions that existed at the end of the reporting period If an event giving rise to a loss contingency occurs after the year-end, a liability should not be accrued. Instead, a disclosure note should be made © 2013 The McGraw-Hill Companies, Inc.

33. Slide 33 Unasserted Claims and Assessments Q1. Is a claim or assessment probable? No Yes No disclosure needed Unasserted claim Q2. Evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated. Q2. Evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated. If the answer to question 1 and 2 are ___ and ___ respectively.. No, [n.a.]Yes, YesYes, No Make a subjective evaluation whether the likelihood of loss is remote or possible. No disclosure is required for contingencies where the likelihood of loss is remote. Recognize a provision Disclose a contingent liability IAS 37 does not deal specifically with these claims; this process is from U.S. GAAP © 2013 The McGraw-Hill Companies, Inc.

34. Slide 34 Contingent Assets As a general principle, we never record contingent assets. Note that the we have to record liabilities even if the likelihood is “probable” and not certain. © 2013 The McGraw-Hill Companies, Inc.

35. McGraw-Hill /Irwin Slide 35 Employers incur several expenses and liabilities from having employees. Appendix 13 ─ Payroll-Related Liabilities © 2013 The McGraw-Hill Companies, Inc.

36. Slide 36 Social Security Taxes Medical Insurance National Income Tax State and Local Income Taxes Voluntary Deductions Gross Pay Net Pay Payroll-Related Liabilities © 2013 The McGraw-Hill Companies, Inc.

37. Slide 37 Amounts withheld depend on each country’s laws, the employee’s earnings, tax rates, and number of withholding allowances. Employers must pay the taxes withheld from employees’ gross pay to the appropriate government agency. National Income Tax State and Local Income Taxes Employees’ Withholding Taxes © 2013 The McGraw-Hill Companies, Inc.

38. Slide 38 Amounts withheld depend on the employee’s request. Employers owe voluntary amounts withheld from employees’ gross pay to the designated agency. Voluntary Deductions Examples include union dues, savings accounts, pension contributions, insurance premiums, charities. Voluntary Deductions © 2013 The McGraw-Hill Companies, Inc.

39. Slide 39 Social Security Taxes Medical insurance Payroll taxes and other welfare-related taxes payable by employer Employers pay amounts equal to that withheld from the employee’s gross pay. Employers’ Payroll Taxes © 2013 The McGraw-Hill Companies, Inc.

40. Slide 40 Fringe Benefits In addition to salaries and wages, withholding taxes, and payroll taxes, most companies provide a variety of fringe benefits. Private health insurance premiums Life insurance premiums Retirement plan contributions Employers must pay the amounts promised to fund employee fringe benefits to the designated agency. © 2013 The McGraw-Hill Companies, Inc.

41. McGraw-Hill /Irwin End of Chapter 13 © 2013 The McGraw-Hill Companies, Inc.