CHAPTER 13 Current Liabilities and Contingencies ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions Brief Exercises Exercises Problems Concepts for Analysis 1, 16 1, 2 1, 2 1, 2 1, 2 Concept of liabilities; definition and classification of current liabilities 1, 2, 3, 4, 6, 8, 19 Accounts and notes payable; current maturities of longterm debt 6, 7, 31 1, 2, 3, 4 2, 16 Shortterm obligations expected to be refinanced 9, 10 3, 4 Dividends payable, customer advances and deposits, unearned revenue. 5, 11, 12, 31 5 Sales taxes and income taxes payable 1, 2 7, 16 2 Employeerelated liabilities 13, 14, 15, 16, 31 7, 8, 9 5, 6, 8, 9, 16 3, 4 Contingencies (general) 17, 18, 19, 20, 22 10, 11, 12, 13, 14, 15 13, 16 10, 11, 13 4, 5, 6 Selfinsurance; litigation, claims, and assessments 27, 28 10, 11 13, 16 10, 11, 13 4, 5, 6 Guaranties and warranties 21, 23 13, 14 10, 11, 16 5, 6, 7, 12, 13, 14 6, 7 10 Premiums and coupons offered to customers 24, 25 15 12, 15, 16 8, 9, 12, 14 11 Environmental liabilities 26 12 13, 14, 16 13 12 Presentation and analysis 29, 30, 31 16, 17, 18, 19 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 131 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Brief Exercises Exercises Problems 1, 2 Describe the nature, type, and valuation of current liabilities 1, 2, 3, 4, 5, 6 1, 2, 7 Explain the classification issues of shortterm debt expected to be refinanced 3, 4 Identify types of employeerelated liabilities 7, 8, 9 5, 6, 8, 9 3, 4 Identify the criteria used to account for and disclose gain and loss contingencies 10, 11, 12, 13, 14, 15 13 7, 10, 11, 13 Explain the accounting for different types of loss contingencies 10, 11, 12, 13, 14, 15 10, 11, 12, 13, 14, 15 2, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14 Indicate how to present and analyze liabilities and contingencies 16, 17, 18, 19 132 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ASSIGNMENT CHARACTERISTICS TABLE Ite m Description Level of Difficu lty Time (minut es) E131 E132 E133 E134 E135 E136 E137 E138 E139 E1310 E1311 E1312 E1313 E1314 E1315 E1316 E1317 E1318 E1319 Balance sheet classification of various liabilities Accounts and notes payable Refinancing of shortterm debt Refinancing of shortterm debt Compensated absences Compensated absences Adjusting entry for sales tax Payroll tax entries Payroll tax entries Warranties Warranties Premium entries Contingencies Asset retirement obligation Premiums Financial statement impact of liability transactions Ratio computations and discussion Ratio computations and analysis Ratio computations and effect of transactions Simple Moderate Simple Simple Moderate Moderate Simple Simple Simple Simple Moderate Simple Moderate Moderate Moderate Moderate Simple Simple Moderate 10–15 15–20 10–12 20–25 25–30 25–30 5–7 10–15 15–20 10–15 15–20 15–20 20–30 25–30 20–30 20–25 10–15 20–25 15–25 P131 P132 P133 P134 P135 P136 P137 P138 P139 P1310 P1311 P1312 P1313 P1314 Current liability entries and adjustments Liability entries and adjustments Payroll tax entries Payroll tax entries Warranties, accrual, and cash basis Extended warranties Warranties, accrual, and cash basis Premium entries Premium entries and financial statement presentation Loss contingencies: entries and essay Loss contingencies: entries and essays Warranties and premiums Liability errors Warranty and coupon computation Simple Simple Moderate Simple Simple Simple Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate 25–30 25–35 20–30 20–25 15–20 10–20 25–35 15–25 30–45 25–30 35–45 20–30 25–35 20–25 CA131 CA132 CA133 CA134 CA135 CA136 CA137 Nature of liabilities Current versus noncurrent classification Refinancing of shortterm debt Loss contingencies Loss contingency Warranties and loss contingencies Warranties Moderate Moderate Moderate Simple Simple Simple Moderate 20–25 15–20 20–25 15–20 15–20 15–20 20–25 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 133 LEARNING OBJECTIVES *7 Describe the nature, type and valuation of current liabilities Explain the classification issues of shortterm debt expected to be refinanced Identify types of employeerelated liabilities Identify the criteria used to account for and disclose gain and loss contingencies Explain the accounting for different types of loss contingencies Indicate how to present and analyze liabilities and contingencies Compare the accounting procedures for current liabilities and contingencies under GAAP and IFRS. 134 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) CHAPTER REVIEW Chapter 13 presents a discussion of the nature and measurement of items classified on the balance sheet as current liabilities. Attention is focused on the mechanics involved in recording current liabilities and financial statement disclosure requirements. Also included is a discussion concerning the identification and reporting of contingent liabilities Current Liabilities (L.O. 1) In general, liabilities involve future disbursements of assets or services. According to the FASB, a liability has three essential characteristics: (a) it is a present obligation that entails settlement by probable future transfer or use of cash, goods, or services; (b) it is an unavoidable obligation; and (c) the transaction or other event creating the obligation has already occurred. Liabilities are classified on the balance sheet as current obligations or longterm obligations. Current liabilities are those obligations whose liquidation is reasonably expected to require use the of existing resources properly classified as current assets or the creation of other current liabilities The relationship between current assets and current liabilities is an important factor in the analysis of a company’s financial condition. Thus, the definition of current liabilities for a particular industry will depend upon the time period (operating cycle or one year, whichever is longer) used in defining current assets in that industry Accounts Payable Accounts payable represents obligations owed to others for goods, supplies, and services purchased on open account. These obligations, commonly known as trade accounts payable, should be recorded to coincide with the receipt of the goods or at the time title passes to the purchaser. Attention must be paid to transactions occurring near the end of one accounting period and at the beginning of the next to ascertain that the record of goods received (inventory) is in agreement with the liability (accounts payable) and that both are recorded in the proper period Notes Payable Notes payable are written promises to pay a certain sum of money on a specified future date and may arise from sales, financing, or other transactions. Notes may be classified as shortterm or longterm, depending on the payment due date Shortterm notes payable resulting from borrowing funds from a lending institution may be interestbearing or zerointerestbearing. Interestbearing notes payable are reported as a liability at the face amount of the note along with any accrued interest payable. A zero interestbearing note does not explicitly state an interest rate on the face of the note Interest is the difference between the present value of the note and the face value of the Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 135 note at maturity. For example, Burke Co. borrowed $138,000 from a bank by giving the bank a oneyear, zerointerestbearing note that has a face amount of $150,000. The entry to record this transaction on Burke’s books is as follows: Cash Discount on Notes Payable Notes Payable 138,000 12,000 150,000 The balance in the Discount on Notes Payable account is a contra account deducted from the Notes Payable account on the balance sheet The currently maturing portion of longterm debt is classified as a current liability. When a portion of longterm debt is so classified, it is expected that the amount will be paid within the next 12 months out of funds classified as current assets Refinancing (L.O. 2) Certain shortterm obligations expected to be refinanced on a longterm basis should be excluded from current liabilities A shortterm obligation is excluded from current liabilities if (a) it is intended to be refinanced on a longterm basis and (b) the ability to accomplish the refinancing is reasonably demonstrated. Both conditions must exist before the item can be excluded from current liabilities Evidence as to the intent and ability to refinance usually comes from actually refinancing or existing refinancing agreements Dividends Payable 10 Cash dividends payable are classified as current liabilities when declared Once declared, a cash dividend is a binding obligation of a corporation payable to its stockholders. Stock dividends distributable are reported in the stockholders’ equity section when declared as they do not require future outlays of assets or services, therefore do no meet the definition of a liability. Customer Advances and Deposits 11 When returnable deposits are received from customers or employees, a liability corresponding to the asset received is recorded The classification of these items as current or noncurrent liabilities is dependent on the time involved between the date of the deposit and the termination of the relationship that required the deposit Unearned Revenues 12 A company sometimes receives cash in advance of the performance of services or issuance of merchandise. Such transactions result in a credit to a deferred or unearned revenue account classified as a current liability on the balance sheet. As claims of this nature are redeemed, the liability is reduced and a revenue account is credited 136 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Sales Taxes Payable 13 Current tax laws require most retailers to collect sales tax from customers and periodically remit these collections to the appropriate governmental unit In such instances, the retailer is acting as a collection agency for a third party If tax amounts due to governmental units are on hand at the financial statement date, they are reported as current liabilities 14 To illustrate the collection and remittance of sales tax by a company, assume that Bentham Company rang up $230,000 on its cash registers during the period. Bentham is subject to a 7% sales tax collection that must be remitted to the State. Bentham’s policy is to record the total amount of sales with sales taxes in the Sales Revenue account. To determine the sales taxes to be remitted to the State, divide the $230,000 by 1.07 to yield the amount of sales for the period, $214,953.27. Of the $230,000 total, $214,953.27 is sales revenue and the difference of $15,046.73 is the amount of sales taxes collected due to the taxing unit. The entry to record the sales tax liability is: Sales Revenue Sales Taxes Payable 15,046.73 15,046.73 When payment is made, the Sales Taxes Payable account is debited and Cash is credited 15 A corporation should estimate and record the amount of income tax liability as computed on its income tax return Chapter 19 discusses in detail the complexities involved in accounting for the difference between taxable income under the tax laws and accounting income under generally accepted accounting principles EmployeeRelated Liabilities 16 (L.O. 3) Amounts owed to employees for salaries or wages of an accounting period are reported as a current liability The following additional items are related to employee compensation and are reported as current liabilities until paid: a Payroll deductions b Compensated absences c Bonuses 17 Payroll deductions include Social Security taxes, income tax withholding amounts, and certain other amounts authorized by employees, such as health insurance and union dues. Social Security taxes consist of both FICA and Hospital Insurance (Medicare) tax Employers must pay an additional share of Social Security taxes, along with both state and federal unemployment taxes. Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 137 18 The following illustrates the concept of accrued liabilities related to payroll deductions Assume Mill Company has a weekly payroll of $25,000 that is entirely subject to FICA and Medicare (7.65%), federal unemployment tax (.8%), and state unemployment tax (3%) Income tax withholding amounts to $3,300, and employee credit union deductions for the week total $975 No employee’s wages exceed the $7,000 compensation ceiling got unemployment taxes. Two entries are necessary to record the payroll: (1) salaries and wages paid to employees, and (2) employer’s payroll taxes The two entries are as follows: Salaries and Wages Expense Withholding Taxes Payable FICA Taxes Payable Credit Union Payments Payable Cash 25,000 Payroll Tax Expense FICA Taxes Payable FUTA Taxes Payable SUTA Taxes Payable 2,863 3,300 1,913 975 18,812 1,913 200 750 19 Compensated absences are absences from employment—such as vacation, illness, and holidays—for which it is expected that employees will be paid In connection with compensated absences, vested rights exist when an employer has an obligation to make payment to an employee even if that employee terminates Accumulated rights are those rights that can be carried forward to future periods if not used in the period in which earned 20 The accounting profession requires that a liability be accrued for the cost of compensation for future absences if all of the following conditions are met: (a) the employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered, (b) the obligation relates to the rights that vest or accumulate, (c) payment of the compensation is probable, and (d) the amount can be reasonably estimated. If an employer fails to accrue a liability because of a failure to meet only condition (d), that fact should be disclosed The expense and related liability for compensated absences should be recognized in the year earned by employees Thus, if employees are entitled to a two week vacation after working one year, the vacation pay is considered to be earned during the first year. The entry to accrue the accumulated vacation pay at the end of year one will include a debit to Salaries and Wages Expense and a credit to Salaries and Wages Payable 21 Bonus agreements are common incentives established by companies for certain key executives or employees. In many cases, the bonus is dependent upon the amount of income earned by the company. However, because the bonus is an expense used in determining net income, it must be deducted before net income can be computed. As a result, there is the need to solve an algebraic formula to compute the bonus. In addition, when the concept of income taxes is added to the formula, calculation of the bonus requires solving simultaneous equations 138 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Contingencies 22 (L.O. 4) A contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur Gain contingencies are not recorded and are disclosed in the notes only when the probabilities are high that a gain contingency will be realized Loss Contingencies 23 (L.O 5) Loss contingencies involve possible losses Contingent liabilities depend upon the occurrence or nonoccurrence of one or more future events to resolve its status When a loss contingency exists, the likelihood that the future event or events will confirm the incurrence of a liability and are categorized as probable, reasonably possible, or remote 24 If the realization of a loss contingency that could result in a liability (1) is probable (likely to occur) and (2) the amount of the loss can be reasonably estimated, a liability is recognized This liability should be recorded along with a charge to income in the period in which the determination is made. It is important to note that both conditions listed above must be met before a liability can be recorded. In addition, note disclosure should describe the nature of the contingency. 25 If a loss is either probable or estimable, but not both, and if there is at least a reasonable possibility that a liability may have been incurred, then the financial statements should include the following footnote disclosures: (a) the nature of the contingency, and (b) an estimate of the possible loss, range of loss, or indication that an estimate cannot be made 26 In instances where a possible loss is remote, no liability is accrued or disclosed in the notes. Litigation, Claims, and Assessments 27 When a company is threatened by legal action such as litigation, claims, and assessments, the recording of a liability will depend upon certain factors. Among the more prevalent are: (a) the time period in which the underlying cause for action occurred, (b) the probability of an unfavorable outcome, and (c) the ability to make a reasonable estimate of the amount of loss Warranties 28 A warranty (product guarantee) represents a promise by a seller to a buyer to make good on any deficiency of quantity, quality or performance specifications in a product. Product warranty costs may be accounted for using the cashbasis method or the accrualbasis method. 29 The cashbasis method must be used when (1) it is not probable that a liability has been incurred or (2) the amount of the liability cannot be reasonably estimated. Under the Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 139 cashbasis method, warranty costs are charged to expense as they are incurred (when they are paid by the seller). No liability is recorded under the cashbasis method for future costs arising from warranties 30 The accrualbasis method includes two different accounting treatments: (a) the expense warranty approach and (b) the sales warranty approach The expense warranty method is the generally accepted method for financial accounting purposes and is viewed as a loss contingency. It should be used whenever the warranty is an integral and inseparable part of the sale. Under the expense warranty method, the estimated warranty expense is recorded in the year in which the item subject to the warranty is sold. When the warranty is honored in a subsequent period, the liability is reduced by the amount of the expenditure to repair the item. For example, if 200 units are sold and the estimated warranty cost is $300 per unit, the following entry is made to accrue warranty expense: Warranty Expense Warranty Liability 60,000 60,000 Actual expenditures made to honor the warranty will debit the liability account and credit cash 31 The sales warranty method defers a certain percentage of the original sales price until some future time when actual costs are incurred or the warranty expires. This method is used when warranties are sold separately from the product and are often called extended warranties. Premiums and Coupons 32 If a company offers premiums to customers in return for proof of purchase items such as product barcodes, box tops, and labels Printed coupons and rebates often used as marketing tools as well. The costs of premiums and coupons should be recognized as an expense in the period of the sale that benefits from the plan A liability should be recognized for outstanding premium offers expected to be redeemed Environmental Liabilities 33 A company must recognize an asset retirement obligation (ARO) when it has an existing legal obligation associated with the retirement of a longlived asset and when it can reasonably estimate the amount of the liability. A company initially measures an ARO at fair value, which is the amount that the company would pay in an active market to settle the ARO. A company includes the cost associated with the ARO in the carrying amount of the related longlived asset, and records a liability for the same amount. In subsequent periods, companies allocate the cost of the ARO to expense over the asset’s useful life. 1310 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) SelfInsurance 34 Selfinsurance is not insurance, but risk assumption. The conditions for accrual according to GAAP are not satisfied prior to the occurrence of the event Presentation and Analysis of Current Liabilities 35 (L.O. 6) Current liabilities are reported in the financial statements at their maturity value Present value techniques are not normally used in measuring current liabilities because of the short time periods involved. Current liabilities are normally listed at the beginning of the liabilities section of the balance sheet. Within the current liability section, the accounts may be listed in order of maturity, in descending order of amount, or in order of liquidation preference 36 If a shortterm obligation is excluded from current liabilities because of refinancing, a footnote to the financial statements should include: (a) a general description of the financing agreement, (b) the terms of any new obligation incurred or to be incurred, and (c) the terms of any equity security issued or to be issued Analysis of Current Liabilities 37 Two ratios often used to analyze liquidity are the current ratio and the acidtest ratio Liquidity regarding a liability is the expected time to elapse before its payment Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1311 LECTURE OUTLINE This chapter can be covered in two or three class sessions. Students should be familiar with trade and payroll liabilities. Shortterm obligations expected to be refinanced and the accounting for loss contingencies are the conceptually challenging areas for many students A (L.O. 1) The Concept of Liabilities The question of what is a liability is not simple to answer This can be seen if preferred stock is analyzed In general, liabilities involve future disbursements of assets or services. According to the FASB, a liability has three essential characteristics: (a) it is a present obligation that entails settlement by probable future transfer or use of cash, goods, or services; (b) it is an unavoidable obligation; and (c) the transaction or other event creating the obligation has already occurred. B Current Liabilities Nature of current liabilities: Obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities Current liabilities are recorded and reported at their full maturity value C Typical Current Liabilities Accounts Payable. Balances owed to others for goods or services purchased on open account Notes Payable. Written promises to pay a certain sum of money on a specified future date a Trade notes b Shortterm notes. Such notes represent a current liability and generally are the result of cash loans. The notes may be interestbearing or zerointerest bearing (1) Interestbearing notes. The borrower receives the face value of the note and records the note at face value (2) Zerointerestbearing notes. The borrower receives an amount equal to the face value of the note less the interest. The note is recorded at its face value and the “prepaid” interest is recorded in a Discount on Notes Payable account c Current maturities of longterm debt. That portion of longterm debt that matures within the next fiscal year is reported as a current liability, unless it is to be refinanced by a new debt issue or by conversion into stock 1312 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) D (L.O. 2) Shortterm obligations expected to be refinanced T EACHING T IP Illustration 131 can be used to discuss the classification of shortterm obligations expected to be refinanced Excluded from current liabilities only if the firm: a Intends to refinance the liability on a longterm basis, and b Demonstrates an ability to refinance Ability can be evidenced by: a Actual refinancing by issuing a longterm liability or equity securities between the balance sheet date and the date the financial statements are issued, or b Signing a refinancing agreement that clearly permits refinancing of the debt on a longterm basis with readily determinable terms Amounts excluded from current liabilities cannot exceed the amount available under the agreement Refinancing must occur before the current debt is due E Dividends Payable. At the date of declaration of a cash dividend, the corporation assumes a liability Preferred dividends in arrears are not a legal obligation until a payment is formally declared Stock dividends are reported as part of stockholders’ equity and are not a liability Customer advances and deposits Unearned revenues Sales taxes payable Income taxes payable a Levied by state, federal, and some municipalities b Proprietorships and partnerships are not taxable entities c Interim tax payments are based on estimates of the total annual tax liability Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1313 F (L.O. 3) Employeerelated liabilities Payroll deductions and taxes a b c Social security taxes (FICA). A combination of the OASDI tax and the Hospital Insurance Tax (1) Paid by both the employee and employer (2) 7.65% on wages up to $113,700 and 1.45% on wages in excess of this amount for 2013 Unemployment taxes. Paid by the employer and not a cost to employees (1) FUTA is 0.8% on the first $7,000 of compensation paid to each employee (2) SUTA is 5.4% of the same $7,000 ceiling. All states provide merit rating credits which often enable employers to pay a reduced rate. Income tax withholding. Federal and state income taxes on employee earnings which are deducted from employees’ paychecks Compensated absences. Vacations, illnesses, and holidays for which employees are normally paid. A liability has to be accrued for future absences if all the following conditions are met: a The obligation arises from services already rendered by the employee b The rights vest or accumulate (1) Vested rights. An obligation to pay an employee exists even if employ ment is terminated (2) Accumulated rights. Can be carried forward to future periods if not used in the period earned c Payment of the compensation is probable d The amount can be reasonably estimated Bonus arrangements. Usually considered additional wages and should be reported a compensation expense. G (L.O. 4) Contingencies. Existing conditions, situations, or sets of circumstances involving uncertainty as to possible gains (gain contingency) or losses (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur 1314 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Gain contingencies. Not recorded and are only disclosed when the probability is high that it will become a reality Loss contingencies. Result in recognition of a contingent liability if certain criteria are met H. (L.O. 5) Loss Contingencies. Contingent liabilities depend on the occurrence of one or more future events to confirm either the amount payable, the payee, the date payable, or its existence. The condition had to exist at the balance sheet date. Information has to be available prior to issuing financial statements T EACHING T IP Use Illustration 132 to discuss the concepts of probable, reasonably possible, and remote in the context of loss contingencies The likelihood that the future event or events will confirm the incurrence of a liability can be classified as: a Probable. The future event or events are likely to occur. A liability is recognized in the balance sheet if the information indicates that it is probable that a liability had been incurred at the balance sheet date and the amount of the loss can be reasonably estimated b Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely c Remote. The chance of the future event or events occurring is slight Accrual of a loss contingency should be made if both of the following conditions are met: a It is probable that a liability has been incurred at the date of the financial statements b The amount of the loss can be reasonably estimated Note disclosure is required when a loss is reasonable possibly, and the amount of the loss cannot be reasonably estimated. Common loss contingencies a Litigation, claims, and assessments. The following factors should be considered (1) The time period in which the underlying cause of action occurred (2) The probability of an unfavorable outcome Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1315 b (3) The ability to make a reasonable estimate of the amount of loss Guarantee and warranty costs. The amount of the liability is an estimate of all the costs that will be incurred after sale and delivery (1) Cashbasis method: Companies expense warranty costs as incurred (2) Accrual methods: Companies expense warranty costs in the year of sale (i) Expense warranty approach. This method should be used whenever the warranty is an integral and inseparable part of the sale and requires warranty costs to be charged to operating expense in the year of sale (ii) Sales warranty approach. This method is used when the warranty is sold separately from the product and requires that revenues from the sale of the warranty be deferred and subsequently recognized as income over the life of the warranty contract c Premiums and coupons offered to customers. Result in the probable existence of a liability at the date of the financial statement d Environmental liabilities (1) Asset retirement obligation (ARO) (i) Waste, contamination, and other environmental effects are often caused by the use of certain longlived assets. The EPA has the power to clean up waste sites and charge the cleanup to parties deemed responsible. (ii) ARO liabilities are recognized when there is an existing legal obligation associated with the retirement of a longlived asset and the amount can be reasonably estimated (2) An ARO should be measured at fair value (i) The amount the company would be required to pay in an active market to settle the ARO (ii) If no active market exists, use an estimate (iii) May be based on present value techniques (3) The cost of the ARO is included in the cost of the related longlived asset (i) A liability is recorded for the same amount (ii) The cost is expensed through the depreciation expense recognized on the related longlived asset 1316 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) e Selfinsurance. The absence of insurance does not mean that a liability has been incurred at the date of the financial statements (1) Accrual is required only if uninsured losses resulting from injury to others or damage to other’s property took place prior to the financial statement date and a reasonable estimate of the amount can be made T EACHING T IP The accounting treatment of loss contingencies can be summarized with the aid of Illustration 133 I (L.O. 6) Presentation of current liabilities Because of their shortterm nature, current liabilities are reported at their full maturity value, not their present value The current liabilities accounts are generally the first classification in the liabilities section of the balance sheet Current liabilities are frequently listed in order of maturity, in descending order of amount, or in order of liquidation preference Disclosures for shortterm obligations expected to be refinanced should include: a A general description of the financing agreement b The terms of any new obligation incurred or to be incurred c The terms of any equity security issued or to be issued Secured liabilities should be identified and the related pledged assets clearly indicated Currently maturing debt to be paid with noncurrent assets should be classified as long term liabilities J Presentation of Contingencies If a loss contingency is either probable or estimable but not both, and if there is at least a reasonable possibility that a liability may have been incurred, the following disclosure is required: a The nature of the contingency b An estimate of the possible loss or range of loss or a statement that an estimate cannot be made Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1317 Other contingent liabilities that should be disclosed even if the possibility of a loss is remote are: a Guarantees of indebtedness to others b Obligations of commercial banks under “standby letters of credit.” c Guarantees to repurchase receivables (or any related property) that have been sold or assigned Disclosure should include the nature and amount of the guarantee and, if estimable, the amount to be recovered from outside parties K Analysis of current liabilities Measures a company’s ability to pay its current obligations as they become due Current ratio = Current assets Current liabilities A more stringent measure of a company’s ability to pay it obligations with assets that can be quickly converted to cash Acidtest ratio = Cash + Shortterm investments + Net receivables Current liabilities T EACHING T IP Use Illustration 134 to discuss the liquidity ratios *L. IFRS Insights IFRS and GAAP have similar definitions for liabilities. IFRS related to reporting and recognition of liabilities is found in IAS 1 (“Presentation of Financial Statements”) and IAS 37 (“Provisions, Contingent Liabilities, and Contingent Assets”) Relevant Facts a Similarities (1) Similar to U.S. practice, IFRS requires that companies present current and noncurrent liabilities on the face of the statement of financial position (balance sheet), with current liabilities generally presented in order of liquidity. However, many companies using IFRS present noncurrent liabilities before current liabilities on the statement of financial position 1318 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) (2) The basic definition of a liability under GAAP and IFRS is very similar. In a more technical way, liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits Liabilities may be legally enforceable via a contract or law but need not be. That is, they can arise due to normal business practices or customs (3) FRS requires that companies classify liabilities as current or noncurrent on the face of the statement of financial position (balance sheet), except in industries where a presentation based on liquidity would be considered to provide more useful information(such as financial institutions) b Differences (1) Under IFRS, the measurement of a provision related to a contingency is based on the best estimate of the expenditure required to settle the obligation. If a range of estimates is predicted and no amount in the range is more likely than any other amount in the range, the “midpoint” of the range is used to measure the liability. In GAAP, the minimum amount in a range is used (2) Both IFRS and GAAP prohibit the recognition of liabilities for future losses However, IFRS permits recognition of a restructuring liability, once a company has committed to a restructuring plan. GAAP has additional criteria (i.e., related to communicating the plan to employees) before a restructuring liability can be established (3) IFRS and GAAP are similar in the treatment of asset retirement obligations (AROs). However, the recognition criteria for an ARO are more stringent under GAAP: The ARO is not recognized unless there is a present legal obligation and the fair value of the obligation can be reasonably estimated (4) Under IFRS, shortterm obligations expected to be refinanced can be classified as noncurrent if the refinancing is completed by the financial statement date GAAP uses the date the financial statements are issued (5) IFRS uses the term provisions to refer to estimated liabilities Under IFRS, contingencies are not recorded but are often disclosed The accounting for provisions under IFRS and estimated liabilities under GAAP are very similar (6) GAAP uses the term contingency in a different way than IFRS Contingent liabilities are not recognized in the financial statements under IFRS, whereas under GAAP, a contingent liability is sometimes recognized Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1319 ILLUSTRATION 131 CLASSIFICATION OF SHORTTERM OBLIGATIONS EXPECTED TO BE REFINANCED 1320 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 132 LOSS CONTINGENCIES Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1321 ILLUSTRATION 133 ACCOUNTING TREATMENT OF LOSS CONTINGENCIES 1322 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 134 CURRENT AND ACIDTEST RATIOS Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1323 ... Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 1321 ILLUSTRATION 133 ACCOUNTING TREATMENT OF LOSS CONTINGENCIES ... Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 133 LEARNING OBJECTIVES *7 Describe the nature, type and valuation of current liabilities... 134 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) CHAPTER REVIEW Chapter 13 presents a discussion of the nature and measurement of items classified on