Chapter 13

Current Liabilities and Contingencies

Characteristics of Liabilities

Result from past transactio

ns or events.

Result from past transactio

ns or events.

Arise from

present obligatio

ns to other

entities.

Arise from

present obligatio

ns to other

entities.

Probable future

sacrifices of

economic benefits.

Probable future

sacrifices of

economic benefits.

Characteristics of Liabilities:

Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements.

Some liabilities may not be payable in cash in future.

A liability is a present obligation to sacrifice assets in the future

because of something that already has occurred.

What is a Current Liability?

LIABILITIESLIABILITIES

Long-term Liabilities

Long-term Liabilities

Expected to be satisfied with current

assets or by the creation of other current liabilities.

Expected to be satisfied with current

assets or by the creation of other current liabilities.

Current LiabilitiesCurrent Liabilities

Obligations payable within one year or one

operating cycle, whichever is longer.

Obligations payable within one year or one

operating cycle, whichever is longer.

Current Liabilities

Current Liabilitie

s

Short-term notes

payable

Accrued expense

s

Cash dividends payable

Taxes payable

Accounts

payable

Unearned

revenues

CURRENT LIABILITIES

GENERAL MILLS, INC. BALANCE SHEET ($ IN MILLIONS)MAY 29, 2011 AND MAY 30, 2010

ASSETS[BY CLASSIFICATION]

LIABILITIESCURRENT LIABILITIES: 2011 2010 Accounts payable $ 995.1 $849.5 Current portion of long-term debt 1,031.3 107.3 Notes payable 311.3 1,050.1Other current liabilities 1,321.5 1,769.1 Total current liabilities $3,659.2 $3,769.1

LONG-TERM LIABILITIES: [LISTED INDIVIDUALLY]

Shareholders’ equity[BY SOURCE]

Salaries, Commissions, and Bonuses

Compensation expenses such as salaries,

commissions, and bonuses are liabilities at the balance

sheet date if earned but unpaid.

These accrued expenses/accrued

liabilities are recorded with an adjusting entry

prior to preparing financial statements.

Vacations, Sick Days, and OtherPaid Future Absences

Sick pay quite often meets the conditions for accrual, but accrual is not mandatory because future absence depends on future illness, which usually is not a certainty.

An employer should accrue an expense and the related liabilityfor employees’ compensation for future absences (such asvacation pay) if the obligation meets all four of these conditions:1.The obligation is for services already performed.2.The paid absence can be taken in a later year—the benefitvests or the benefit can be accumulated over time.3.Payment is probable.4.The amount can be reasonably estimated.

Exercise 13–4Wages expense (increases wages expense to $410,000) 6,000

Liability—compensated future absences 6,000*

* ($404,000 – 4,000] = $400,000 non-vacation wages x 1/40 = 10,000 vacation pay earned

(4,000) vacation pay taken = $ 6,000 vacation pay carried over

 Exercise 13–5Requirement 1 Wages expense (700 x $900) 630,000

Liability—compensated future absences 630,000

Requirement 2 Liability—compensated future absences 630,000Wages expense ($31 million + [5% x $630,000]) 31,031,500

Cash (or wages payable) (total) 31,661,500 

Liabilities from Advance Collections

Refundable deposits Advances from customers Gift cards Collections for third parties

Refundable deposits Advances from customers Gift cards Collections for third parties

Customer Advance

A customer advance produces an obligation that is satisfied when the product or service is provided. Tomorrow Publications collects magazine subscriptions from customers at the time subscriptions are sold. Subscription revenue is recognized over the term of the subscription. Tomorrow collected $20 million in subscription sales during its first year of operations. At December 31, the average subscription was one-fourth expired.

($ in millions)When Advance is Collected

Cash 20Unearned subscriptions revenue 20

When Product is DeliveredUnearned subscriptions revenue 5

Subscriptions revenue 5 Common example: Gift cards. Earn the revenue when either the gift card is used or the probability of redemption is viewed as remote.

Exercise 13–6: Customer Advances (Gift Cards) & Sales taxesRequirement 1

Cash 5,200Liability—gift certificates 5,200

Cash ($2,100 + 84 – 1,300) 884Liability—gift certificates 1,300

Sales revenue 2,100Sales taxes payable (4% x $2,100) 84

Requirement 2 Gift certificates sold $5,200Gift certificates redeemed (1,300)Liability to be reported at December 31 $3,900

Requirement 3 The sales tax liability is a current liability because it is payable in January.The liability for gift certificates is part current and part noncurrent:

Gift certificates sold $5,200 x 80%

Estimated current liability $4,160Gift certificates redeemed (1,300)Current liability at December 31 $2,860Noncurrent liability at December 31 ($5,200 x 20%) 1,040 Total $3,900

A Closer Look at the Current andNoncurrent Classification

Debt that is callable by the lender in the coming year (or operating cycle, if

longer) should be classified as a current liability, even if the debt is not

expected to be called.

Debt that is callable by the lender in the coming year (or operating cycle, if

longer) should be classified as a current liability, even if the debt is not

expected to be called.

Current maturities of long-term obligations usually are reclassified and reported as current liabilities if they are

payable within the upcoming year (or operating cycle, if longer than a year).

Current maturities of long-term obligations usually are reclassified and reported as current liabilities if they are

payable within the upcoming year (or operating cycle, if longer than a year).

NOTE ISSUED FOR CASH Interest Bearing Notes:

FACE AMOUNT x ANNUAL RATE x TIME TO MATURITY On May 1, Affiliated Technologies, Inc., a consumer electronics firm, borrowed $700,000 cash from First BancCorp under a noncommitted short-term line of credit arrangement and issued a 6-month, 12% promissory note. Interest was payable at maturity.

May 1Cash 700,000

Notes payable 700,000

November 1Interest expense ($700,000 x 12% x 6/12) 42,000Notes payable 700,000

Cash ($700,000 + 42,000) 742,000

Noninterest-Bearing NoteThe proceeds of the note are reduced by the interest in a “noninterest-bearing” note.Situation: $700,000 noninterest-bearing note, with a 12% “discount rate.” The $42,000 interest is “discounted” at the outset, rather than explicitly stated: May 1Cash (difference) 658,000Discount on notes ($700,000 x 12% x 6/12) 42,000

Notes payable (face amount) 700,000

November 1Interest expense 42,000

Discount on notes 42,000

Notes payable (face amount) 700,000Cash 700,000

EFFECTIVE INTEREST RATEThe amount borrowed is only $658,000, but the interest is calculated as the discount rate times the $700,000 face amount. This causes the effective interest rate to be higher than the 12% stated rate:

$ 42,000 interest for 6 months ÷ $658,000 amount borrowed= 6.38% rate for 6 monthsx 12/6 to annualize the rate= 12.76% effective interest rate

ACCRUED LIABILITIES  Liabilities accrue for expenses that are incurred, but not yet paid.

Recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements.

Common examples are: salaries and wages payable, income taxes payable, and interest payable. 

ACCRUED INTEREST PAYABLE On May 1, Affiliated Technologies, Inc., a consumer electronics firm, borrowed $700,000 cash from First Banc Corp under a non-committed short-term line of credit arrangement and issued a 6-month, 12% promissory note. Interest was payable at maturity. The fiscal period for Affiliated Technologies ends on June 30, two months after the 6-month note is issued.

The issuance of the note, intervening adjusting entry, and note payment would be recorded as shown below:

Issuance of note May 1Cash 700,000

Note payable 700,000

Accrual of interest on June 30Interest expense ($700,000 x 12% x 2/12) 14,000

Interest payable 14,000

Note payment November 1Interest expense ($700,000 x 12% x 4/12) 28,000Interest payable (from adjusting entry) 14,000Note payable 700,000

Cash ($700,000 + 42,000) 742,000

The ability to refinance on a long-term basiscan be demonstrated by an existing refinancing agreement, or actual financing prior to issuance of the financial statements.

The ability to refinance on a long-term basiscan be demonstrated by an existing refinancing agreement, or actual financing prior to issuance of the financial statements.

Short-Term ObligationsExpected to be Refinanced

A company may reclassify a short-term liability as long-term if two conditions are met:

A company may reclassify a short-term liability as long-term if two conditions are met:

It has the intent to refinance on a long-term basis.

It has the intent to refinance on a long-term basis.

It has demonstrated the ability to refinance.

It has demonstrated the ability to refinance.

and

INTERNATIONAL FINANCIAL REPORTING STANDARDS Classification of Liabilities to be Refinanced. Under U.S. GAAP, liabilities payable within the coming year are classified as long-term liabilities if refinancing is completed before date of issuance of the financial statements.

Under IFRS, refinancing must be completed before the balance sheet date.

Exercise 13–11Normally, short-term debt (payable within a year) is classified as current liabilities. However, when such debt is to be refinanced on a long-term basis, it should be included with long-term liabilities.

The narrative indicates that Sprint has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis.

Thus, Sprint reported the debt as long-term liabilities.

Exercise 13–12Requirement 1 Normally, IFRS requires that short-term debt (payable within a year) be classified as current liabilities.

However, when such debt is to be refinanced on a long-term basis, it may be included with long-term liabilities.

The narrative indicates that Sprint has both (1) the intent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis.

Thus, Sprint reported the debt as long-term liabilities.

Requirement 2 IFRS requires that the refinancing capability be in place as of the balance sheet date. Therefore, given that the refinancing was not arranged until after year-end, IFRS would require that the debt be classified as a current liability.

Exercise 13

Loss Contingencies

A loss contingency is an existing uncertain situation

involving potential loss depending on whether some future event occurs.

A loss contingency is an existing uncertain situation

involving potential loss depending on whether some future event occurs.

Two factors affect whether a loss contingency must be accrued and

reported as a liability:1. The likelihood (probability) that the

confirmingevent will occur.

2. Whether the loss amount can be reasonably estimated.

Two factors affect whether a loss contingency must be accrued and

reported as a liability:1. The likelihood (probability) that the

confirmingevent will occur.

2. Whether the loss amount can be reasonably estimated.

KnownReasonably Estimable

Not Reasonably Estimable

Liability accrued and disclosure note

Liability accrued and disclosure note

Disclosure note only

Disclosure note only

Disclosure note only

Disclosure note only

No disclosure required

No disclosure required

No disclosure required

Estimatible (Dollar Amount of Potential Loss)

Likelihood

Probable

Reasonably possible

Remote

Loss Contingencies

A loss contingency is accrued only if a loss is probable A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.and the amount can reasonably be estimated.

A loss contingency is accrued only if a loss is probable A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.and the amount can reasonably be estimated.

Exercise 13-17 Brief Exercises 13, 14, 15, 16

IFRS defines “probable” as “more likely than not” (greater than 50%), which is a lower threshold than typically associated with “probable” in U.S. GAAP. If a liability is accrued, IFRS measures the liability as the best estimate of the expenditure required to settle the present obligation.

If there is a range of equally likely outcomes, IFRS would use the midpoint of the range, while U.S. GAAP requires use of the low end of the range.

Brief Exercises 17

Product Warranties and Guarantees

Product warranties inevitably entail costs. The amount of those costs can be

reasonably estimated using commonly available estimation techniques.

The estimate requires the following entry:

Product warranties inevitably entail costs. The amount of those costs can be

reasonably estimated using commonly available estimation techniques.

The estimate requires the following entry:

Warranty expense ......................................... $,$$$Estimated warranty liability .............. $,$$$

To accrue warranty expense.

Exercise 13-15, Brief Exercise 12

Extended Warranty Contracts

Extended warranties are sold separately from the product.

The related revenue is not earned until: Claims are made against the

extended warranty, or The extended warranty period

expires.

Extended warranties are sold separately from the product.

The related revenue is not earned until: Claims are made against the

extended warranty, or The extended warranty period

expires.

Exercise 13-16

Premiums

Premiums included with the product are expensed in the period of sale.

Premiums that are contingent on action by the customer require accounting similar to warranties.

Premiums included with the product are expensed in the period of sale.

Premiums that are contingent on action by the customer require accounting similar to warranties.

Exercise 13-19

Litigation Claims

The majority of medium- and large-size corporations annually report loss contingencies due to litigation.

The most common disclosure is a note to the financial statements.

The majority of medium- and large-size corporations annually report loss contingencies due to litigation.

The most common disclosure is a note to the financial statements.

Subsequent Events

Events occurring between the fiscal year-end date and report date can

affect the appearance of disclosures on the financial statements.

Events occurring between the fiscal year-end date and report date can

affect the appearance of disclosures on the financial statements.

Fiscal Year Ends Financial Statements

ClarificationCause of Loss Contingency

Subsequent Events

Events occurring after the year-end date but before the financial statements can

also affect the appearance of disclosures on the financial statements.

Events occurring after the year-end date but before the financial statements can

also affect the appearance of disclosures on the financial statements.

Fiscal Year Ends Financial Statements

ClarificationCause of Loss Contingency

Unasserted Claims and Assessments

Is a claimIs a claimor assessmentor assessment

probable?probable?

Is a claimIs a claimor assessmentor assessment

probable?probable?No

Yes

NoNodisclosuredisclosure

neededneeded

NoNodisclosuredisclosure

neededneeded

UnassertedUnassertedclaimclaim

UnassertedUnassertedclaimclaim

Evaluate (a) the likelihood of an unfavorable outcome andEvaluate (a) the likelihood of an unfavorable outcome and(b) whether the dollar amount can be estimated.(b) whether the dollar amount can be estimated.

An estimated loss and contingent liability would beaccrued if an unfavorable outcome is probable and the

amount can be reasonably estimated.

Evaluate (a) the likelihood of an unfavorable outcome andEvaluate (a) the likelihood of an unfavorable outcome and(b) whether the dollar amount can be estimated.(b) whether the dollar amount can be estimated.

An estimated loss and contingent liability would beaccrued if an unfavorable outcome is probable and the

amount can be reasonably estimated.

Gain Contingencies

As a general As a general rule, we never rule, we never record record GAINGAIN

contingencies.contingencies.

Note that the prior rules Note that the prior rules have supported the have supported the recording of recording of LOSSLOSS

contingencies.contingencies.

End of Chapter 13