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Chapter  10

Introduction  to  Liabilities:  Economic  Consequences,  Current  Liabilities    and  

Contingencies

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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.”

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The  Relative  Size  of  Liabilities  on  the  Balance  Sheet

Figure  10-­1  Liabilitiesas  a  percentage  of  totalassets

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  

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Figure  10-­2  Current  liabilitiesas  a  percentage  of  totalliabilities

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.

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Determinable  /  Contingent  Liabilities

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Figure  10-­3  Outline  of  current  liabilities

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

� Incentive  compensation

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The  dollar  value  of  theseliabilities  is  relatively  straightforward  – hence  determinable

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

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Figure  10-­4  Bonus  formulas  of  selected  large  corporations  for  executive  compensation  pools

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.

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Loss  Contingencies

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Figure  10-­5  Accounting  for  contingencies

• A  promise  by  a  manufacturer  or  seller  to  ensure  the  quality  or  performance  of  the  product  for  a  specific  period  of  time

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Warranty

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 xxCash xx

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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  onbest  estimate.

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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 52,000Cash 690,000

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Class  Exercise:  E10-­‐10(a)(1)  GJE  to  record  sale  in  2014  (200  @  $250  each):

Cash 50,000Sales  revenue 50,000

(2)  AJE  in  2014  to  record  estimated  warranty  for  the  sales  (200  @  $20):

Warranty  expense 4,000Contingent  Warranty  Liability 4,000

(3)  GJE  to  record  payment  in  2014  for  repairs:Contingent  Warranty  Liability 1,400

Cash 1,400GJE  to  record  payment  in  2015  for  repairs:

Contingent  Warranty  Liability 2,600Cash 2,600

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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  Paid2011   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.

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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

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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  LiabilityCr.  Cash

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• 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.

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Cont’d  Appendix  10A  Retirement  Costs

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%

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App  B  -­‐ The  Concept  of  Deferred  Income  Taxes

2012  Deferred  income  tax  liability  $900

2013  Deferred  income  tax  benefit  $300

2014  Deferred  income  tax  benefit  $600§24

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

App  B  -­‐ Deferred  Income  Taxes:  Additional  Issues

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Figure  10B-­3  Deferred  income  tax  liability  (selected  U.S.  companies)

Appendix  B  -­‐ The  Conservatism  Ratio

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Figure  10B-­4  Conservatism  Ratios

Conservatism  Ratio:  Reported  Income  before  Taxes/Taxable  Income

Knowing  that  companies  defer  taxable  income,  a  measure  around1.0  or  less  indicates  relative  conservatism.    Reported  income  is  increasingly  less  conservative  at  ratios  greater  than  1.0.

Appendix  B  -­‐ The  Conservatism  Ratio

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Figure  10B-­5  The  conservatism  ratio  of  General  Electric  (dollars  in  millions)

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