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CHAPTER 13
Current Liabilities and Contingencies
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Concept of liabilities; definition and classification of current liabilities.
- Accounts and notes payable; dividends payable.
- Deposits and advance payments.
- Collections for third parties. 14 5, 6 5, 6, 7, 16 3, 4
- Compensated absences and bonuses.
- Short-term obligations expected to be refinanced.
- Contingent liabilities (General).
- Guaranties and warranties. 22, 23 13, 14 10, 11, 16 1, 5, 6, 7, 12, 13, 14
- Premiums and awards offered to customers.
- Self-insurance, litigation, claims, and assessments, asset retirement obligations.
- Presentation and analysis. 29, 30, 31 17, 18, 19 6, 9, 13 3
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Questions Brief Exercises Exercises Problems
Concepts for Analysis
- Describe the nature, valuation, and reporting of current liabilities.
- Explain the classification issues of short- term debt expected to be refinanced.
- Explain the accounting for gain and loss contingencies.
- Indicate how to present and analyze liabilities and contingencies.
ANSWERS TO QUESTIONS
- Current liabilities are obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities. Long-term debt consists of all liabilities not properly classified as current liabilities.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- You might explain to your friend that the accounting profession at one time prepared financial statements somewhat in accordance with the broad or loose definition of a liability submitted by the AICPA in 1953: “Something represented by a credit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting, provided such credit balance is not in effect a negative balance applicable to an asset. Thus the word is used broadly to comprise not only items which constitute liabilities in the proper sense of debts or obligations (including provision for those that are unascertained), but also credit balances to be accounted for which do not involve the debtor and creditor relation.”
Since your friend may not have completely understood the above definition (if it may be called that), you might indicate that more recent definitions of liabilities call for the disbursement of assets or services in the future and that the present value of all of a person’s or company’s future disbursements of assets constitutes the total liabilities of that person or company. But, accountants quantify or measure only those liabilities or future disbursements which are reasonably determinable at the present time. And, accountants have accepted the completed transaction as providing the objectivity or basis necessary for financial recognition. Therefore, a liability may be viewed as an obligation to convey assets or perform services at some time in the future and is based upon a past or present transaction or event. A formal definition of liabilities presented in Concepts Statement No. 6 is as follows: Probable future sacrifices 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.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- As a lender of money, the banker is interested in the priority his/her claim has on the company’s assets relative to other claims. Close examination of the liability section and the related footnotes discloses amounts, maturity dates, collateral, subordinations, and restrictions of existing contractual obligations, all of which are important to potential creditors. The assets and earning power are likewise important to a banker considering a loan.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets, or the creation of other current liabilities.
Because current liabilities are by definition tied to current assets and current assets by definition are tied to the operating cycle, liabilities are related to the operating cycle.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Unearned revenue is a liability that arises from current sales but for which some services or products are owed to customers in the future. At the time of a sale, customers pay not only for the delivered product, but they also pay for future products or services (e.g., another plane trip, hotel room, or software upgrade). In this case, the company recognizes revenue from the current product and part of the sale proceeds is recorded as a liability (unearned revenue) for the value of future products or services that are “owed” to customers. Market analysts indicate that an increase in the unearned revenue liability, rather than raising a red flag about liquidity often provides a positive signal about sales and profitability. When the sales are growing, its unearned revenue account should grow. Thus, an increase in a liability may be good news about company performance. In contrast, when unearned revenues decline, the company owes less future amounts but this also means that sales of new products may have slowed.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued)
- Payables and receivables generally involve an interest element. Recognition of the interest element (the cost of money as a factor of time and risk) results in valuing future payments at their current value. The present value of a liability represents the debt exclusive of the interest factor.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- A discount on notes payable represents the difference between the present value and the face value of the note, the face value being greater in amount than the discounted amount. It should be treated as an offset (contra) to the face value of the note and amortized to interest expense over the life of the note. The discount represents interest expense chargeable to future periods.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Liabilities that are due on demand (callable by the creditor) should be classified as a current liability. Classification of the debt as current is required because it is a reasonable expectation that existing working capital will be used to satisfy the debt. Liabilities often become callable by the creditor when there is a violation of the debt agreement. Only if it can be shown that it is probable that the violation will be cured (satisfied) within the grace period usually given in these agreements can the debt be classified as noncurrent.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- A cash dividend formally authorized by the board of directors would be recorded by a debit to Retained Earnings and a credit to Dividends Payable. The Dividends Payable account should be classified as a current liability.
An accumulated but undeclared dividend on cumulative preferred stock is not recorded in the accounts as a liability until declared by the board, but such arrearages should be disclosed either by a footnote to the balance sheet or parenthetically in the capital stock section.
A stock dividend distributable, formally authorized and declared by the board, does not appear as a liability because a stock dividend does not require future outlays of assets or services and is revocable by the board prior to issuance. Even so, an undistributed stock dividend is generally reported in the stockholders’ equity section since it represents retained earnings in the process of transfer to paid-in capital.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Unearned revenue arises when a company receives cash or other assets as payment from a customer before conveying (or even producing) the goods or performing the services which it has committed to the customer.
Unearned revenue is assumed to represent the obligation to the customer to refund the assets received in the case of nonperformance or to perform according to the agreement and thus earn the unrestricted right to the assets received. While there may be an element of unrealized profit included among the liabilities when unearned revenues are classified as such, it is ignored on the grounds that the amount of unrealized profit is uncertain and usually not material relative to the total obligation.
Unearned revenues arise from the following activities: (1) The sale by a transportation company of tickets or tokens that may be exchanged or used to pay for future fares. (2) The sale by a restaurant of meal tickets that may be exchanged or used to pay for future meals. (3) The sale of gift certificates by a retail store. (4) The sale of season tickets to sports or entertainment events. (5) The sale of subscriptions to magazines.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued)
- A determinable current liability is susceptible to precise measurement because the date of payment, the payee, and the amount of cash needed to discharge the obligation are reasonably certain. There is nothing uncertain about (1) the fact that the obligation has been incurred and (2) the amount of the obligation.
A contingent liability is an obligation that is dependent upon the occurrence or nonoccurrence of one or more future events to confirm the amount payable, the payee, the date payable, or its existence. It is a liability dependent upon a “loss contingency.”
Current liabilities—accounts payable, notes payable, current maturities of long-term debt, dividends payable, returnable deposits, sales and use taxes, payroll taxes, and accrued expenses.
Contingent liabilities—obligations related to product warranties and product defects, premiums offered to customers, certain pending or threatened litigation, certain actual and possible claims and assessments, and certain guarantees of indebtedness of others.
LO: 3, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The terms probable, reasonably possible, and remote are used in GAAP to denote the chances of a future event occurring, the result of which is a gain or loss to the enterprise. If it is probable that a loss has been incurred at the date of the financial statements, then the liability (if reasonably estimable) should be recorded. If it is reasonably possible that a loss has been incurred at the date of the financial statements, then the liability should be disclosed via a footnote. The footnote should disclose (1) the nature of the contingency and (2) an estimate of the possible loss or range of loss or a statement that an estimate cannot be made. If the incurrence of a loss is remote, then no liability need be recorded or disclosed (except for guarantees of indebtedness of others, which are disclosed even when the loss is remote).
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Under U.S. GAAP, companies may not record provisions for future operating losses. Such provi- sions do not meet the definition of a liability, since the amount is not the result of a past transaction (the losses have not yet occurred). Therefore the liability has not been incurred. Furthermore, operating losses reflect general business risks for which a reasonable estimate of the loss could not be determined. Note that use of provisions in this way is one of the examples of earnings management discussed in Chapter 4. By reducing income in good years through the use of loss contingencies, companies can smooth out their income from year-to-year.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Companies do not record a separate performance obligation for assurance-type warranties. This type of warranty is nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These types of obligations should be expensed in the period the goods are provided or services performed (in other words, at the point of sale). In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur after sale due to the correction of defects or deficiencies required under the warranty provisions.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued)
- Companies record a service-type warranty as a separate performance obligation. For example, in the case of the television, the seller recognizes the sale of the television with the assurance-type warranty separately from the sale of the service-type warranty. The sale of the service-type warranty is usually recorded in an Unearned Warranty Revenue account. Companies then recognize revenue on a straight-line basis over the period the service-type warranty is in effect. Companies only defer and amortize costs that vary with and are directly related to the sale of the contracts (mainly commissions). Companies expense employees’ salaries and wages, advertising, and general and administrative expenses because these costs occur even if the company did not sell the service-type warranty.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Southeast Airlines Inc.’s award plan is in essence a discounted ticket sale. Therefore, the full-fare ticket should be recorded as unearned transportation revenue (liability) when sold and recognized as revenue when the transportation is provided. The half-fare ticket should be treated accordingly; that is, record the discounted price as unearned transportation revenue (liability) when it is sold and recognize it as revenue when the transportation is provided.
LO: 3, Bloom: AN, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- In the case of a free ticket award, a portion of the ticket fares contributing to the accumulation of the 50,000 miles (the free ticket award level) be deferred as unearned transportation revenue and recognized as revenue when free transportation is provided. The total amount deferred for the free ticket should be based on the revenue value to the airline and the deferral should occur and accumulate as mileage is accumulated.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- An asset retirement obligation must be recognized when a company has an existing legal obligation associated with the retirement of a long-lived asset and when the amount can be reasonably estimated.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The absence of insurance does not mean that a liability has been incurred at the date of the financial statements. Until the time that an event (loss contingency) occurs there can be no diminution in the value of property or incurrence of a liability. If an event has occurred which exposes an enterprise to risks of injury to others and/or damage to the property of others, then a contingency exists. Expected future injury, damage, or loss resulting from lack of insurance need not be recorded or disclosed if no contingency exists. And, a contingency exists only if an uninsurable event which causes probable loss has occurred. Lack of insurance is not in itself a basis for recording a liability or loss.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- In determining whether or not to record a liability for pending litigation, the following factors must be considered: (a) The time period in which the underlying cause for action occurred. (b) The probability of an unfavorable outcome. (c) The ability to make a reasonable estimate of the amount of loss.
Before recording a liability for threatened litigation, the company must determine: (a) The degree of probability that a suit may be filed, and (b) The probability of an unfavorable outcome.
If both are probable, the loss reasonably estimable, and the cause for action dated on or before the date of the financial statements, the liability must be accrued.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 13-
(a) Since both criteria are met (intent and ability), none of the $500,
would be reported as a current liability. The entire amount would be
reported as a long-term liability.
(b) Because repayment of the note payable required the use of existing
12/31/17 current assets, the entire $500,000 liability must be reported
as current. (This assumes Burr had not entered into a long-term
agreement prior to issuance.)
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 13-
(a) Lawsuit Loss ........................................................... 900,
Lawsuit Liability ............................................. 900,
(b) No entry is necessary. The loss is not accrued because it is not prob-
able that a liability has been incurred at 12/31/17.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 13-
Buchanan should record a litigation accrual on the patent case, since the
amount is both estimable and probable. This entry will reduce income by
$300,000 and Buchanan will report a litigation liability of $300,000. The
$100,000 self-insurance allowance has no impact on income or liabilities.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 13-
Oil Platform ..................................................................... 450,
Asset Retirement Obligation ................................ 450,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 13-
During 2017
Warranty Expense ........................................ 70,
Inventory ..................................................... 70,
Cash ............................................................. 1,000,
Sales ............................................................ 1,000, 000
Warranty Expense ........................................ 55,
Warranty Liability ...................................... 55,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 13-
(a) Cash ....................................................................... 1,980,
Unearned Warranty Revenue
(20,000 X $99) ............................................ 1,980,
(b) Warranty Expense ................................................. 180,
Inventory ....................................................... 180,
(c) Unearned Warranty Revenue ............................... 495,
Warranty Revenue
($1,980,000 ÷ 4) .......................................... 495,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
BRIEF EXERCISE 13-
Premium Expense ............................................................. 96,
Premium Liability ..................................................... 96,000*
*UPC codes expected to be sent in (30% X 1,200,000) ... 360,
UPC codes already redeemed ......................................... 120,
Estimated future redemptions ......................................... 240,
Cost of estimated claims outstanding
(240,000 ÷ 3) X ($1.10 + $0.60 – $0.50) .......................... $ 96,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
EXERCISE 13-2 (Continued)
Dec. 31
(b) Interest Expense.................................... 1,
Interest Payable ............................ 1,
($50,000 X 8% X 3/12)
Dec. 31
Interest Expense.................................... 1,
Discount on Notes Payable ......... 1,
($4,000 X 3/12)
(c) (1) Notes payable $50,
Interest payable 1,
(2) Notes payable $54,
Less discount ($4,000 – $1,000) 3,
LO: 1, Bloom: AP, Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 13-3 (25–30 minutes)
(a) 2016
To accrue expense and liability for vacations
Salaries and Wages Expense 24,
Salaries and Wages Payable ................. 7,200 (1)
To accrue the expense and liability for sick pay
Salaries and Wages Expense 30,
Salaries and Wages Payable ................. 4,
To record payment for compensated time when used by employees
Salaries and Wages Payable .......................... 2,880 (3)
Cash ........................................................ 2,
EXERCISE 13-3 (Continued)
To accrue the expense and liability for vacations
Salaries and Wages Expense ......................... 7,
Salaries and Wages Payable ................. 7,920 (4)
To accrue the expense and liability for sick pay
Salaries and Wages Expense ......................... 4,
Salaries and Wages Payable ................. 4,752 (5)
To record vacation time paid
Salaries and Wages Expense ......................... 648
Salaries and Wages Payable .......................... 6,480 (6)
Cash ........................................................ 7,128 (7)
To record sick leave paid
Salaries and Wages Expense ......................... 144
Salaries and Wages Payable .......................... 3,816 (8)
Cash ........................................................ 3,960 (9)
(1) 9 employees X $10.00/hr. X 8 hrs./day X 10 days = $7,
(2) 9 employees X $10.00/hr. X 8 hrs./day X 6 days = $4,
(3) 9 employees X $10.00/hr. X 8 hrs./day X 4 days = $2,
(4) 9 employees X $11.00/hr. X 8 hrs./day X 10 days = $7,
(5) 9 employees X $11.00/hr. X 8 hrs./day X 6 days = $4,
(6) 9 employees X $10.00/hr. X 8 hrs./day X 9 days = $6,
(7) 9 employees X $11.00/hr. X 8 hrs./day X 9 days = $7,
(8) 9 employees X $10.00/hr. X 8 hrs./day X (6–4) days = $1,
9 employees X $11.00/hr. X 8 hrs./day X (5–2) days = $2,376 = $3,
(9) 9 employees X $11.00/hr. X 8 hrs./day X 5 days $3,
Note: Vacation days and sick days are paid at the employee’s current wage.
Also, if employees earn vacation pay at different pay rates, a consistent pattern
of recognition (e.g., first-in, first-out) could be employed to determine which
liabilities have been paid.
EXERCISE 13-4 (25–30 minutes)
(a) 2016
To accrue the expense and liability for vacations
Salaries and Wages Expense ............... 7,740 (1)
Salaries and Wages Payable ........ 7,
To record sick leave paid
Salaries and Wages Expense ............... 2,880 (2)
Cash............................................... 2,
To record vacation time paid
No entry, since no vacation days were used.
To accrue the expense and liability for vacations
Salaries and Wages Expense ............... 8,352 (3)
Salaries and Wages Payable ........ 8,
To record sick leave paid
Salaries and Wages Expense ............... 3,960 (4)
Cash............................................... 3,
To record vacation time paid
Salaries and Wage Expense ................. 162
Salaries and Wages Payable................. 6,966 (5)
Cash............................................... 7,128 (6)
(1) 9 employees X $10.75/hr. X 8 hrs./day X 10 days = $7,
(2) 9 employees X $10.00/hr. X 8 hrs./day X 4 days = $2,
(3) 9 employees X $11.60/hr. X 8 hrs./day X 10 days = $8,
(4) 9 employees X $11.00/hr. X 8 hrs./day X 5 days = $3,
(5) 9 employees X $10.75/hr. X 8 hrs./day X 9 days = $6,
(6) 9 employees X $11.00/hr. X 8 hrs./day X 9 days = $7,
EXERCISE 13-4 (Continued)
(b) Accrued liability at year-end:
Jan. 1 balance $ 0 $7,
+ accrued 7,740 8,
Dec. 31 balance $7,740(1) $9,126(2)
(1) 9 employees X $10.75/hr. X 8 hrs./day X 10 days = $7,
(2) 9 employees X $10.75/hr. X 8 hrs./day X 1 day = $ 774
9 employees X $11.60/hr. X 8 hrs./day X 10 days = 8,
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
EXERCISE 13-5 (5–7 minutes)
June 30
Sales Revenue ................................................................. 21,
Sales Tax Payable .................................................. 21,
Computation:
Sales plus sales tax ($233,200 + $153,700) $386,
Sales exclusive of tax ($386,900 ÷ 1.06) 365,
Sales tax $ 21,
LO: 1, Bloom: AP, Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 13-6 (10–15 minutes)
Salaries and Wages Expense ......................................... 480,
Withholding Taxes Payable ................................... 80,
FICA Taxes Payable* .............................................. 29,
Union Dues Payable ............................................... 9,
Cash ........................................................................ 361,
*[($480,000 – $110,000) X 7.65% = $28,
$110,000 X 1.45% = $1,595; $28,305 + $1,595 = $29,
