Other Liabilities

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21 Other Liabilities

ProfitDebit Credit or

Loss

Expenses

BALANCE SHEET INCOME STATEMENT

Assets Liabilities Revenue

Equity

Learning Objectives1. Account for estimated liabilities

involving warranties and rebates

2. Account for estimated liabilities arising from compensated absences and bonus plans

3. Explain accounting issues involving estimated and deferred income tax

4. Explain accounting issues involving contingent liabilities

5. Analysis: Compute and explain working capital as a percentage of sales

Other liabilities

both current and long term

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Liabilities -definitionThe FASB definition of a liability includes these 3 essential

elements:

1. It is an obligation in effect that must be settled by giving up cash, goods or services in the future.

2. It is an obligation that cannot be avoided.3. The event that created the obligation has already occurred.

In this chapter we will study several liabilities that could meet this definition but may:

Require an estimate as to the size of the liability, the date it must be paid and the party to whom it will be paid

Exhibit uncertainty as to whether the liability will occur

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Objective 21.1: Account for estimated liabilities involving warranties and

rebates

O21.1

Estimated liabilities are known obligations of an uncertain amount.

They often also exhibit uncertainty as to the date they must be paid and the

party to whom they will be paid.

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O21.1

Firms often guarantee their products and services under a warranty agreement. Based on the expected occurrence of claims, they must follow the Matching Concept and expense the warranty repair or replacement in the same fiscal period as the sales that involved the warranty.

Matching Concept

Account for estimated liabilities involving warranties and rebates

WARRANTY

We guarantee. . .

WARRANTY

We guarantee. . .

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O21.1

Firms also offer inducements to generate sales and develop customer loyalty through the use of marketing innovations such as cash rebates. This additional expense, must follow the Matching Concept and be included in the same fiscal period as the sales that these inducements helped generate.

Matching Concept


$25 Rebate

With the purchase of. . .

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O21.1

Problem -When the warranty or rebate is expensed, the firm doesn’t know precisely:

•Who will be paid•How much or how many will be paid•When they will be paid

Solution -Estimate the warranty and rebate expense expected

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O21.1

WARRANTY

We guarantee. . .

WARRANTY

We guarantee. . .

Warranty liabilities

After sale obligations arising from guaranty agreements for products and servicesEstimates must be used to predict expected warranty claimsWarranty liability and expense must be recorded in the same period as sales subject to the warranty

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O21.1

$25 Rebate

With the purchase of. . .

Rebate liabilities

Subject to a sale, cash, product or service obligation to a customerEstimates must be used to predict amounts that must be paid based on expected redemption ratesRebate liability and expense must be recorded in the same period as the sales subject to the incentive

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O21.1

Example WARRANTY–On January 1, Greenline Engine Rebuilders began to offer a 2 year 20,000 mile parts and labor warranty on their rebuilt auto and truck engines. Management estimates that warranty expenses will average 3% of net sales.

As of December 31, net sales = $2,350,000. Estimated warranty claims are: $2,350,000 x 3% = $70,500

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Date Description PR Debit Credit

Adjusting Entries

12/31/10 Warranty Expense 565 70,500

Estimated Warranty Liability 238 70,500

GENERAL JOURNAL


Loss

Expenses



Equity

Greenline will report $70,500 less net

income as a result of this adjustment.

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1/1/11 Estimated Warranty Liability 238 500

Cash 100 500

GENERAL JOURNAL

O21.1

Example WARRANTY–In January following the first year of the warranty agreement, a customer submitted a claim for $500 for warranty repairs made on a Greenline engine.

Note that the debit does not go to an expense account, it reduces the Warranty Liability. This obligation has already been expensed in the prior fiscal period.


Loss

Expenses



Equity

No change in net income as a result of

this transaction

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Adjusting Entries

1/31/11 Rebate Expense 590 20,000

Estimated Rebate Liability 241 20,000

GENERAL JOURNAL

O21.1

Example REBATE –On January 1, YardMax Tools began to offer a $25 mail-in rebate on the purchase of their new garden tiller. Management estimates that 40% of customers will submit the mail-in rebate. The sales price for the new tiller is $425.

Sales totaled $850,000. Estimated rebate expense: $850,000/$425 = 2000 tillers x 40% x $25 = $20,000


Loss

Expenses



Equity

YardMax will report $20,000 less net

income

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Objective 21.2: Account for estimated liabilities arising from compensated

absences and bonus plans

O21.2

Compensated absence plans include:

Vacations Sick pay Holidays Family leave

earned by employees

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O21.2

FASB rules indicate these expenses should be accrued if the following conditions are met:

•The obligation to compensate for absences arises from services already rendered by the employee.•The obligation is related to rights for time off that vest or accumulate•Payment is probable•Amounts can be reasonably estimated

Account for estimated liabilities arising from compensated absences and bonus plans

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O21.2

Vested rights exist when the employee has a right to the benefit even if terminated Accumulated rights exists when benefits can be carried forward into future periods if not used in the current period

Account for estimated liabilities arising from compensated absences and bonus plans

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O21.2

Consider start up firm Barrier Systems who began operation on July 1 (FYE 6/30). Barrier has 10 employees who earn, on average, $625 per week.

Compensated absences -example

During the year employees earned 20 weeks of paid vacation and none was used. $625 x 10 employees x 20 weeks = $125,000

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Adjusting Entries

6/30/11 Vacation Wages Expense 560 125,000

Vacation Wages Payable 240 125,000

GENERAL JOURNAL

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O21.2

In the first month of the subsequent fiscal year, employee Ralph Tonga takes his 2 week vacation. His weekly wage, net of all payroll costs and deductions, is $725.

Compensated absences -example

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7/31/11 Vacation Wages Payable 240 1,450

Cash 100 1,450

GENERAL JOURNAL

Additional entries (i.e. debits to the Vacation Wages Payable & credits to various payroll payable accounts) for employee deductions and the employer payroll costs would be necessary to complete the payroll recording. (See Chapter 8)

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O21.2

Bonus agreements -exampleRidlow Corporation’s bonus plan pools 20% of net profits (after the expense of the profit sharing is deducted) for distribution to all employees weighted by their total annual compensation. Ridlow’s net income before any bonus plan deductions is $1,500,000.

Let B equal the amount of the bonus, then:

B = 20% x ($1,500,000—B)B = $300,000 - .20B

1.20B = $300,000B = $250,000

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Adjusting Entries

12/31/10 Employee's Bonus Expense 595 250,000

Profit Sharing Bonus Payable 265 250,000

GENERAL JOURNAL

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Objective 21.3: Explain accounting issues involving estimated and

deferred income tax

O21.3

The regular C-corporation is subject to federal income taxes which must be accounted for on the corporate financial statements

Estimates are recorded during the tax year based on anticipated taxable income levels

Corporations are required to make estimated quarterly income tax payments to the IRS to avoid penalties

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Explain accounting issues involving estimated and deferred income tax

O21.3

At month end, Nappy Corp estimates the first quarterly tax payments due April 15 to be $22,000.

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Adjusting Entries

3/31/10 Income Tax Expense 598 22,000

Income Taxes Payable 235 22,000

GENERAL JOURNAL

Note that the estimate is

expensed


Loss

Expenses



Equity

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4/12/10 Income Taxes Payable 235 22,000

Cash 100 22,000

Quarterly estimated IRS payment

GENERAL JOURNAL


O21.3

On April 15, the tax payment is made

The payable is satisfied

with the cash payment


Loss

Expenses



Equity

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O21.3

Deferred Income Tax Liabilities

income under GAAP and income under IRS rules is usually different

most differences are temporary* due to timing issues

over longer periods of time (years) different income amounts between IRS and GAAP due to timing are eliminated*except for some permanent differences

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O21.3

GAAP

Pre-tax net Income $30,000

Vision Corporation12/31/10

IRS

Pre-tax net Income $10,000


Consider the different income for the same year under GAAP and IRS for Vision

Corporation:

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O21.3

Why is the income (GAAP vs IRS) different?

Some examples of permanent reasons are:

Permanent GAAP IRS

Is municipal bond interest revenue?

Are fines for legal violations expenses?

YesYes

YesYes NoNo

NoNo

For temporary and permanent reasons.For temporary and permanent reasons.

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O21.3

Why is the income (GAAP vs IRS) different?

Some examples of temporary reasons are: (eventually results will be same for GAAP & IRS)

•Straight line depreciation could be used for GAAP but an accelerated depreciation for IRS •Uncollectible account expense and warranty expense is accrued under GAAP but IRS only allows these to be expensed when cash is actually paid

Due to temporary timing differences in the recognition of revenues and expenses

Due to temporary timing differences in the recognition of revenues and expenses

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O21.3

Keep in mind that we are preparing GAAP statements here

These differences often result in a deferred income tax liability (or asset)

We are obliged to record the federal income tax expense based on the $30,000 GAAP income –

NOT the $10,000 IRS taxable income.

We are obliged to record the federal income tax expense based on the $30,000 GAAP income –

NOT the $10,000 IRS taxable income.

GAAP

Net Income $30,000


IRS

Net Income $10,000


GAAP statements

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The balancing entry of $3,000 is the deferred amount (will be paid in future years)

The balancing entry of $3,000 is the deferred amount (will be paid in future years)


O21.3

If the tax rate is 15% for Vision Corporation, this would require:

15% x $30,000 = $4,500 debit to income tax expense

If the tax rate is 15% for Vision Corporation, this would require:

15% x $30,000 = $4,500 debit to income tax expense

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Deferred Income Tax Liability 298 3,000

GENERAL JOURNAL

The amount currently due (must be paid this period) to the IRS: 15% x $10,000 = $1,500

The amount currently due (must be paid this period) to the IRS: 15% x $10,000 = $1,500

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O21.3

Consider Cascade Corporation net income of $20,000 under GAAP and $50,000 under IRS. Consider Cascade Corporation net income of $20,000 under GAAP and $50,000 under IRS.

These differences can also result in a deferred income tax asset

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Deferred Income Tax Asset 198 4,500


GENERAL JOURNAL

The deferred tax asset will be used up in

future periods.Profit

Debit Credit or

Loss

Expenses



Equity

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Objective 21.4: Explain accounting issues involving contingent liabilities

O21.4

Example:

Consider a product defect lawsuit pending against PNC Corporation. If the firm loses the suit they may be

required to pay substantial amounts.

Contingent liabilities are potential liabilities arising from an existing set of

circumstances

Contingent liabilities are potential liabilities arising from an existing set of

circumstances

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Explain accounting issues involving contingent liabilities

O21.4

Depending on how future events unfold, PNC Corporation could suffer a

loss based on the outcome of the lawsuit.

The loss is uncertain until the lawsuit is

overProfit

Debit Credit or

Loss

Expenses



Equity

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O21.4

FASB rules regarding the recording of contingent liabilities are based on two

questions:

What are the chances the event will occur?

Can the size of the potential loss be reasonably estimated?

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O21.4

FASB assigns three ranges of possibility to the first question.

Probable –The future event is likely to occur

Reasonably possible –The chance of the event occurring is less than likely but more than remote

Remote –The chance of the future event occurring is slight

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O21.4

Probable Reasonably Possible Remote

Can be reasonably estimated

Record the contingent liability

Disclose the contingent liability in financial

statement notes

Take no Action

Cannot be reasonably estimated


statement notes


statement notes

Take no Action

Likelihood of the Loss occurring

Only one of these situations require the

liability to be recorded

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O21.4

Page 124


6/30/10 Estimated loss from pending lawsuit 599 500,000

Estimated liability

from pending lawsuit 299 500,000

GENERAL JOURNAL

Assuming that the PNC corporation product defect lawsuit has been determined to be both probable and can be reasonably estimated as a 500,000 potential loss. . .

The loss is still probable, not 100% certain


Loss

Expenses



Equity

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O21.4

Also:A set of circumstances could possibly result in a gain (i.e. the firm began a lawsuit against another party for damages)

•If the firm wins, a gain could result• However, GAAP rules lean toward the Conservatism Concept in the case of gains and they are not recorded until they actually occur

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Objective 21.5: Analysis: Compute and explain average working capital as a

percentage of sales

O21.5

Working

CapitalCurrent Assets

Current Liabilities

Working capital answers the following question: How many dollars of current

assets would remain if all current liabilities were paid using current

assets? The higher the number, the more liquidity is displayed by the

balance sheet.

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Analysis: Compute and explain average working capital as a percentage of

sales

O21.5

Average Working Capital

Sales

Average working capital =

Working capital (beg.) + Working capital (ending)

2 Average working capital as a percentage of

sales

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Analysis: Compute and explain average working capital as a percentage of

sales

O21.5

Average Working Capital

Sales

Average working capital as a percentage of salesanswers the question: “What level of working capital was necessary to achieve the reported sales for the year?”

Average working

capital as a

percentage of sales

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O21.5

Example

Assets 2009 2010 Liabilities 2009 2010Cash 8,500 7,000 Accounts Payable 121,400 123,600Accounts receivable 41,200 85,700 Current liabilities 121,400 123,600Inventory 76,500 82,300 Long term debt 5,000 4,200

Current assets 126,200 175,000Prop, plant, equip 28,400 31,500 Total liabilities 126,400 127,800

Other assets 0 1,000 Equity Total assets 154,600 207,500 Owner, Capital 28,200 79,700

Sales 598,700

Cost of Goods Sold 449,025 Average working capital (WC) 28,100Wages expense 31,500 (WC for years 2009 +2010) / 2Selling expenses 1,250 WC as a % of Sales 4.7%Interest expense 450 (Net Income / Avg. WC)Miscellaneous expense 64,975 Current ratio 2010 1.4

Net Profit 51,500

Income StatementFor the year ended 12/31/10

Balance Sheet -Kauri SteelAs of 12/31 2009 & 2010

Other Liabilities

Documents

Transcript of Other Liabilities