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2
Chapter 10
Introduction to Liabilities: Economic
Consequences, Current Liabilities
and Contingencies
3
Liabilities
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.”
5
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
7
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.
9
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 tax payable
7. Income taxes payable (App 10B)
8. Payroll taxes payable
10
Determinable CL - continued 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
12
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, much 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.
14
Contingent Liabilities 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:
Estimated Warranty Liability xx
Cash, etc. xx
15
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.
16
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 52,000
Cash 690,000
17
Warranty A promise by a manufacturer or seller to ensure
the quality or performance of the product for a
specific period of time
Almost Honest
JOHN’S
Used Cars
I’ll stand behind it
for 50 miles
or 50 minutes
whichever comes first
18
Class Exercise: E10-10(a) (1) GJE to record sale in 2011 (200 @ $250 each):
Cash 50,000
Sales revenue 50,000
(2) AJE in 2011 to record estimated warranty for the sales (200 @ $20):
Warranty expense 4,000
Estimated Warr. Liability 4,000
(3) GJE to record payment in 2011 for repairs:
Est. Warr. Liability 1,400
Cash 1,400
GJE to record payment in 2012 for repairs:
Est. Warr. Liability 2,600
Cash 2,600
19
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
2011 2012 2011 2012
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.
20
Retirement Costs (App 10A) 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
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
21
Deferred Taxes (App 10B) Generated by the discrepancy between income and
expenses for taxation (specified by IRS) and financial reporting (specified by GAAP).
Example:
– Equipment purchased on 1/1/09 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%
22
Depreciation Schedules
2009 Deferred income tax liability $900
2010 Deferred income tax benefit $300
2011 Deferred income tax benefit $600
Year DDB SL Diff Rate Tax Benefit
(Disbenefit)
2009 $6000 - 3000 = $3000 X 30% = $900
2010 2000 - 3000 = (1000) X 30% = (300)
2011 1000 - 3000 = (2000) X 30% = (600)
Total $9000 $9000 $0 $0
Copyright
26
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