Financial accounting 9th jamie pratt chapter 10



1


Chapter 10

Introduction to Liabilities: Economic Consequences,
Current Liabilities and Contingencies



2


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.”



3


The Relative Size of Liabilities on the Balance Sheet

Figure 10-1
Liabilities
as a percentage of
total
assets



4


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

Figure 10-2 Current

liabilities
as a percentage of
total
liabilities



6


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.



7


Determinable / Contingent Liabilities

Figure 10-3 Outline of current liabilities



8


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

The dollar value of these
liabilities is relatively straight
forward – hence determinable



9


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

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



11

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.



12


Loss Contingencies

Figure 10-5 Accounting for contingencies



13


Warranty

•

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



14


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
Cash

xx
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
Cash

52,000
690,000



17


Class Exercise: E10-10(a)
(1) GJE to record sale in 2014 (200 @ $250 each):
Cash
50,000
Sales revenue

50,000
(2) AJE in 2014 to record estimated warranty for the sales (200 @ $20):
Warranty expense
4,000
Contingent Warranty Liability
4,000
(3) GJE to record payment in 2014 for repairs:
Contingent Warranty Liability
1,400
Cash
1,400
GJE to record payment in 2015 for repairs:
Contingent Warranty Liability
2,600
Cash
2,600



18


Class Exercise: E10-10(b)
Income effects for the revenue and warranty expense under the two alternative for recognition of expense :
Accrue Expense
2011
2012
Revenues
50,000
--Warr. Expense

(4,000)
---

Expense as Paid
2011
2012
50,000 --(1,400) (2,600)

Note: the accrual method recognizes the expense in the same period as the revenues generated by the
sale.



19


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



20


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 Liability
Cr. Cash



21


Cont’d Appendix 10A Retirement Costs

• 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.



22


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%



23


App B - The Concept of Deferred Income Taxes

Year

DDB

SL

Dif

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

Figure 10B-1 Income
tax effects due to DDB
depreciation

$0

2012 Deferred income tax liability $900

2013 Deferred income tax benefit $300

2014 Deferred income tax benefit $600


24

App B - Deferred Income Taxes: Additional Issues

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



25