1 Chapter 10 Introduction to Liabilities: Economic Consequences, Current Liabilities and Contingencies 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.” Liabilities 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 Current Liabilities 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 Figure 10-3 Determinable Current Liabilities Accounts payable (Ch 7) Short-term notes Current maturities of long-term debts Dividends payable Unearned revenues (Ch 5) Sales tax payable Income taxes payable (App 10B) Payroll taxes payable 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 10 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 12 Figure 10-5 13 Contingent Liabilities Warranties – Uncertain future costs – Record estimated expense and liability when products are sold (matching concept): Warranty Expense Estimated Warranty Liability xx xx – As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Estimated Warranty Liability xx Cash, etc xx 14 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 15 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 16 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 17 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 18 Class Exercise: E10-10(b) Income effects for the revenue and warranty expense under the two alternative for recognition of expense (expressed in thousands): Paid Accrue Expense 2011 Revenues 50,000 Warr Expense (4,000) 2012 - Expense as 2011 2012 50,000 (1,400) (2,600) Note that the accrual method recognizes the expense in the same period as the revenues generated by the sale 19 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 20 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% 21 Depreciation Schedules Year DDB SL 2009 $6000 - 3000 = $3000 X 30% = $900 2010 2000 - 3000 = (1000) X 30% = (300) 2011 1000 - 3000 = (2000) X 30% = (600) Total $9000 $9000 Diff Rate Tax Benefit (Disbenefit) $0 $0 2009 Deferred income tax liability $900 2010 Deferred income tax benefit $300 2011 Deferred income tax benefit $600 22 Deferred Income Tax Liability 23 The Conservatism Ratio 24 The Conservatism Ratio 25 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 26 [...]... 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% 21 Depreciation Schedules Year DDB SL 2009 $6000 - 3000 = $3000 X 30% = $900 2010 2000 - 3000...Incentive Compensation 11 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... Estimated Warranty Liability xx xx – As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability: Estimated Warranty Liability xx Cash, etc xx 14 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,... 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... 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 Figure 10-5 13 Contingent Liabilities Warranties – Uncertain future costs – Record estimated expense and liability when products are sold (matching concept): Warranty Expense... 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 16 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... Benefit (Disbenefit) $0 $0 2009 Deferred income tax liability $900 2010 Deferred income tax benefit $300 2011 Deferred income tax benefit $600 22 Deferred Income Tax Liability 23 The Conservatism Ratio 24 The Conservatism Ratio 25 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States... E10-10(b) Income effects for the revenue and warranty expense under the two alternative for recognition of expense (expressed in thousands): Paid Accrue Expense 2011 Revenues 50,000 Warr Expense (4,000) 2012 - Expense as 2011 2012 50,000 (1,400) (2,600) Note that the accrual method recognizes the expense in the same period as the revenues generated by the sale 19 Retirement Costs (App 10A)  Defined... 50 miles or 50 minutes whichever comes first 17 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:... unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 26