CH-13 Current Liabilities and Contingencies – Intermediate Accounting : Book Guide

Chapter 13 Current Liabilities and Contingencies 1 Chapter 13 Current Liabilities and Contingencies QUESTIONS FOR REVIEW OF KEY TOPICS Question 13-1 A liability entails the present, the future, and the past. It is a present responsibility, to sacrifice assets in the future, caused by a transaction or other event that already has happened. Specifically, “Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6, par. 36, describes three essential characteristics: Liabilities– 1. are probable, future sacrifices of economic benefits 2. that arise from present obligations (to transfer goods or provide services) to other entities 3. that result from past transactions or events. Question 13-2 Liabilities traditionally are classified as either current liabilities or long-term liabilities in a classified balance sheet. Current liabilities are those expected to be satisfied with current assets or by the creation of other current liabilities (Committee on Accounting Procedure, American Institute of CPAs, Accounting Research and Terminology Bulletin, Final Edition, p. 21). Usually, but with exceptions, current liabilities are obligations payable within one year or within the firm's operating cycle, whichever is longer. Question 13-3 In concept, liabilities should be reported at their present values; that is, the valuation amount is the present value of all future cash payments resulting from the debt, usually principal and/or interest payments. In this case, the amount would be determined as the present value of $100,000, discounted for three months at an appropriate rate of interest for a debt of this type. This is proper because of the time value of money. In practice, liabilities ordinarily are reported at their maturity amounts if payable within one year because the relatively short time period makes the interest or time value component immaterial. Accounting Principles Board Opinion No 21, “Interest on Receivables and Payables,” specifically exempts from present value valuation all liabilities arising in connection with suppliers in the normal course of business and due within a year. 2 Answers to Questions (continued) Question 13-4 Lines of credit permit a company to borrow cash from a bank up to a prearranged limit at a predetermined, usually floating, rate of interest. The interest rate often is based on current rates of the prime London interbank borrowing, certificates of deposit, bankers’ acceptance, or other standard rates. Lines of credit usually must be available to support the issuance of commercial paper. Lines of credit can be noncommitted or committed. A noncommitted line of credit allows the company to borrow without having to follow formal loan procedures and paperwork at the time of the loan and is less formal, usually without a commitment fee. Sometimes a compensating balance is required to be on deposit with the bank as compensation for the service. A committed line of credit is more formal. It usually requires a commitment fee in the neighborhood of 1/4 of one percent of the unused balance during the availability period. Sometimes compensating balances also are required. Question 13-5 When interest is “discounted” from the face amount of a note at the time it is written, it usually is referred to as a “noninterest-bearing” note. They do, of course entail interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset and included in the amount paid at maturity. In fact, the effective interest rate is higher than the stated discount rate because the discount rate is applied to the face value, but the cash borrowed is less than the face value. Question 13-6 Commercial paper represents loans from other corporations. It refers to unsecured notes sold in minimum denominations of $25,000 with maturities ranging from 30 to 270 days. The firm would be required to file a registration statement with the SEC if the maturity is beyond 270 days. The name “commercial paper” implies that a paper certificate is issued to the lender to represent the obligation. But, increasingly, no paper is created because the entire transaction is computerized. Recording the issuance and payment of commercial paper is the same as for notes payable. The interest rate usually is lower than in a bank loan because commercial paper (a) typically is issued by large, sound companies (b) directly to the lender, and (c) normally is backed by a line of credit with a bank. Question 13-7 This is an example of an accrued expense – an expense incurred during the current period, but not yet paid. The expense and related liability should be recorded as follows: Salaries expense 5,000 Salaries payable 5,000 This achieves a proper matching of this expense with the revenues it helps generate. 3 Answers to Questions (continued) Question 13-8 An employer should accrue an expense and the related liability for employees' compensation for future absences, like vacation pay, if the obligation meets each of four conditions: (1) the obligation is attributable to employees' services already performed, (2) the paid absence can be taken in a later year – the benefit vests (will be compensated even if employment is terminated) or the benefit can be accumulated over time, (3) the payment is probable, and (4) the amount can be reasonably estimated. Customary practice should be considered when deciding whether an obligation exists. For instance, whether the rights to paid absences have been earned by services already rendered sometimes depends on customary policy for the absence in question. An example is whether compensation for upcoming sabbatical leave should be accrued. Is it granted only to perform research beneficial to the employer? Or, is it customary that sabbatical leave is intended to provide unrestrained compensation for past service. Similar concerns also influence whether unused rights to the paid absences can be carried forward or expire. Although holiday time, military leave, maternity leave, and jury time typically do not accumulate if unused, if it is customary practice that one can be carried forward, a liability is accrued if it’s probable employees will be compensated in a future year. Similarly, sick pay is specifically excluded by SFAS 43 from mandatory accrual because future absence depends on future illness, which usually is not a certainty. But, if company policy or custom is that employees are paid “sick pay” even when their absence is not due to illness, a liability for unused sick pay should be recorded. Question 13-9 When a company collects cash from a customer as a refundable deposit or as an advance payment for products or services, a liability is created obligating the firm to return the deposit or to supply the products or services. When the amount is to be returned to the customer in cash, it is a refundable deposit. When the amount will be applied to the purchase price when goods are delivered or services provided (gift certificates, magazine subscriptions, layaway deposits, special order deposits, and airline tickets) it is a customer advance. Question 13-10 Examples of amounts collected for third parties that represent liabilities until remitted are sales taxes, and payroll-related deductions such as federal and state income taxes, social security taxes, employee insurance, employee contributions to retirement plans, and union dues. 4 Answers to Questions (continued) Question 13-11 1. Current liability — The requirement to classify currently maturing debt as a current liability includes debt that is callable, or due on demand, by the creditor in the upcoming year even if the debt is not expected to be called. 2 Long-term liability — The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt is not yet callable, but will be callable within the year if an existing violation is not corrected within a specified grace period – unless it's probable the violation will be corrected within the grace period. In this case, the existing violation is expected to be corrected within 6 months. Question 13-12 Short-term obligations can be reported as noncurrent liabilities if the company (a) intends to refinance on a long-term basis and (b) demonstrates the ability to do so by a refinancing agreement or by actual financing. Question 13-13 A loss contingency is an existing situation, or set of circumstances involving potential loss that will be resolved when some future event occurs or doesn’t occur. Examples: (1) an unsettled tax deficiency assessed by the IRS, (2) a possible uncollectible receivable, (3) being the defendant in a lawsuit. Question 13-14 The likelihood that the future event(s) will confirm the incurrence of the liability must be categorized as: PROBABLE – the confirming event is likely to occur. REASONABLY POSSIBLE– the chance the confirming event will occur is more than remote but less than likely. REMOTE– the chance the confirming event will occur is slight. Question 13-15 A liability should be accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. Question 13-16 If one or both of the accrual criteria is not met, but there is at least a reasonable possibility that an obligation exists (the loss will occur), a disclosure note should describe the contingency. The note also should provide an estimate of the possible loss or range of loss, if possible. If an estimate cannot be made, a statement to that effect should be included. 5 Answers to Questions (continued) Question 13-17 1. Manufacturers’ product warranties — these inevitably involve expenditures, and reasonably accurate estimates of the total liability for a period usually are possible, based on prior experience. 2. Cash rebates and other premium offers — these inevitably involve expenditures, and reasonably accurate estimates of the total liability for a period usually are possible, based on prior experience. Question 13-18 The contingent liability for warranties and guarantees usually is accrued. The estimated warranty (guarantee) liability is credited and warranty (guarantee) expense is debited in the reporting period in which the product under warranty is sold. An extended warranty provides warranty protection beyond the manufacturer’s original warranty. A manufacturer’s warranty is offered as an integral part of the product package. By contrast, an extended warranty is priced and sold separately from the warranted product. It essentially constitutes a separate sales transaction and is recorded as such. Question 13-19 Several weeks usually pass between the end of a company’s fiscal year and the date the financial statements for that year actually are issued. Any enlightening events occurring during this period should be used to assess the nature of a loss contingency existing at the report date. Since a liability should be accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated, the contingency should be accrued. Question 13-20 When a contingency comes into existence only after the year-end, a liability cannot be accrued because none existed at the end of the year. Yet, if the loss is probable and can be reasonably estimated, the contingency should be described in a disclosure note. The note should include the effect of the loss on key accounting numbers affected. Furthermore, even events other than contingencies that occur after the year-end but before the financial statements are issued must be disclosed in a “subsequent events” disclosure note if they have a material effect on the company’s financial position. (i.e., an issuance of debt or equity securities, a business combination, or discontinued operations). 6 Answers to Questions (concluded) Question 13-21 When an assessment is probable, reporting the possible obligation would be warranted if an unfavorable settlement is at least reasonably possible. This means an estimated loss and contingent liability would be accrued if (a) an unfavorable outcome is probable and (b) the amount can be reasonably estimated. Otherwise footnote disclosure would be appropriate. So, when the assessment is unasserted as yet, a two-step process is involved in deciding how it should be reported: 1. Is the assessment probable? If it is not, no disclosure is warranted. 2. If the assessment is probable, evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated to determine whether it should be accrued, disclosed only, or neither. Question 13-22 You should not accrue your gain. A gain contingency should not be accrued. This conservative treatment is consistent with the general inclination of accounting practice to anticipate losses, but to recognize gains only at their realization. Though gain contingencies are not recorded in the accounts, they should be disclosed in notes to the financial statements. Attention should be paid that the disclosure note not give "misleading implications as to the likelihood of realization." 7 BRIEF EXERCISES Brief Exercise 13-1 Cash ................................................................ 60,000,000 Notes payable .............................................. 60,000,000 Interest expense ($60,000,000 x 12% x 3/12) ....... 1,800,000 Interest payable .......................................... 1,800,,000 Brief Exercise 13-2 Cash (difference) .......................................................... 54,600,000 Discount on notes payable ($60,000,000 x 12% x 9/12) . 5,400,000 Notes payable (face amount) .................................... 60,000,000 Interest expense ($60,000,000 x 12% x 3/12) .................. 1,800,000 Discount on notes payable .................................... 1,800,000 Brief Exercise 13-3 a. December 31 $100,000 x 12% x 6/12 = $6,000 b. September 30 $100,000 x 12% x 3/12 = $3,000 8 Brief Exercise 13-4 Cash (difference) .......................................................... 11,190,000 Discount on notes payable ($12,000,000 x 9% x 9/12) ... 810,000 Notes payable (face amount) .................................... 12,000,000 Interest expense ......................................................... 810,000 Discount on notes payable ........................................... 810,000 Notes payable (face amount)......................................... 12,000,000 Cash ....................................................................... 12,000,000 Brief Exercise 13-5 Cash (difference) .......................................................... 9,550,000 Discount on notes payable ($10,000,000 x 6% x 9/12) ... 450,000 Notes payable (face amount) .................................... 10,000,000 Effective interest rate: Discount ($10,000,000 x 6% x 9/12) $ 450,000 Cash proceeds ÷ $9,550,000 Interest rate for 9 months 4.712% x 12/9 ___________ Annual effective rate 6.3% 9 Brief Exercise 13-6 December 12 Cash ....................................................................... 24,000 Liability – customer advance ............................ 24,000 January 16 Cash ....................................................................... 216,000 Liability – customer advance ................................ 24,000 Sales revenue ..................................................... 240,000 Brief Exercise 13-7 Accounts receivable ............................................... 645,000 Sales revenue .................................................... 600,000 Sales taxes payable ([6% + 1.5%] x $600,000) ....... 45,000 10 Brief Exercise 13-8 This is a loss contingency and the estimated warranty liability is credited and warranty expense is debited in the period in which the products under warranty are sold. Right will report a liability of $130,000: Warranty Liability _________________________________________ 150,000 Warranty expense (1% x $15,000,000) Actual expenditures 20,000 130,000 Balance Brief Exercise 13-9 This is a loss contingency and should be accrued because it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. Goo Goo should report a $5.5 million loss in its income statement and a $5.5 million liability in its balance sheet Loss – product recall ....................................................... 5,500,000 Liability - product recall .......................................... 5,500,000 A disclosure note also is appropriate. 11 Brief Exercise 13-10 This is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. A carefully worded disclosure note is appropriate. Brief Exercise 13-11 This is a loss contingency. A liability should be accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met (as in this case), but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the contingency. That’s what Bell should do here. Brief Exercise 13-12 Only the third situation’s costs should be accrued. A liability should be accrued for a loss contingency if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met, but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the contingency. Both criteria are met only for the warranty costs. Brief Exercise 13-13 No disclosure is required because an EPS claim is not yet asserted, and an assessment is not probable. Even if an unfavorable outcome is thought to be probable in the event of an assessment and the amount is estimable, disclosure is not required unless an unasserted claim is probable. 12 EXERCISES Exercise 13-1 Requirement 1 Cash ................................................................ 8,000,000 Notes payable .............................................. 8,000,000 Requirement 2 Interest expense ($8,000,000 x 12% x 2/12) ........ 160,000 Interest payable .......................................... 160,000 Requirement 3 Interest expense ($8,000,000 x 12% x 7/12) ........ 560,000 Interest payable (from adjusting entry) .............. 160,000 Notes payable (face amount) ............................. 8,000,000 Cash (total) ................................................... 8,720,000 Exercise 13-2 1. Interest rate Fiscal year-end 12% December 31 $200 million x 12% x 6/12 = $12 million 2. Interest rate Fiscal year-end 10% September 30 $200 million x 10% x 3/12 = $5 million 3. Interest rate Fiscal year-end 9% October 31 $200 million x 9% x 4/12 = $6 million 4. Interest rate Fiscal year-end 6% January 31 $200 million x 6% x 7/12 = $7 million Exercise 13-3 1. b 2. a 13 Exercise 13-4 2006 Jan. 13 No entry is made for a line of credit until a loan actually is made. It would be described in a disclosure note. Feb. 1 Cash ........................................................................... 5,000,000 Notes payable ......................................................... 5,000,000 May 1 Interest expense ($5,000,000 x 10% x 3/12) ................... 125,000 Notes payable (face amount)......................................... 5,000,000 Cash ($5,000,000 + 125,000) ...................................... 5,125,000 Dec. 1 Cash (difference) .......................................................... 9,325,000 Discount on notes payable ($10,000,000 x 9% x 9/12) ... 675,000 Notes payable (face amount) .................................... 10,000,000 Dec. 31 The effective interest rate is 9.6515% ($675,000 ÷ $9,325,000) x 12/9. So, properly, interest should be recorded at that rate times the outstanding balance times one-twelfth of a year: Interest expense ($9,325,000 x 9.6515% x 1/12) ............. 75,000 Discount on notes payable .................................... 75,000 However the same results are achieved if interest is recorded at the discount rate times the maturity amount times one-twelfth of a year: Interest expense ($10,000,000 x 9% x 1/12) ................... 75,000 Discount on notes payable .................................... 75,000 14 Exercise 13-4 (concluded) 2007 Sept. 1 Interest expense ($10,000,000 x 9% x 8/12)* .................. 600,000 Discount on notes payable .................................... 600,000 Notes payable (balance) ............................................... 10,000,000 Cash (maturity amount) ............................................. 10,000,000 * or, ($9,325,000 x 9.6515% x 8/12) = $600,000 15 Exercise 13-5 Wages 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 13-6 Requirement 1 Wages expense (700 x $900) .............................................. 630,000 Liability – compensated future absences ............ 630,000 Requirement 2 Liability – compensated future absences ................. 630,000 Wages expense ($31 million + [5% x $630,000]) .............. 31,031,500 Cash (or wages payable) (total) ............................. 31,661,500 16 Exercise 13-7 Requirement 1 Cash ............................................................................ 5,200 Liability – gift certificates ..................................... 5,200 Cash ($2,100 + 84 - 1,300) ............................................. 884 Liability – gift certificates ......................................... 1,300 Sales revenue .......................................................... 2,100 Sales taxes payable (4% x $2,100) ............................ 84 Requirement 2 Gift certificates sold $5,200 Gift 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 $4,160 Gift certificates redeemed (1,300) Current liability at December 31 $2,860 Noncurrent liability at December 31 ($5,200 x 20%) 1,040 Total $3,900 17 Exercise 13-8 Requirement 1 Deposits Collected Cash .................................................................. 850,000 Liability – refundable deposits .................... 850,000 Containers Returned Liability – refundable deposits ........................ 790,000 Cash .............................................................. 790,000 Deposits Forfeited Liability – refundable deposits ........................ 35,000 Revenue – sale of containers ........................ 35,000 Cost of goods sold ............................................ 35,000 Inventory of containers ................................ 35,000 Requirement 2 Balance on January 1 $530,000 Deposits received 850,000 Deposits returned (790,000) Deposits forfeited (35,000) Balance on December 31 $555,000 18 Exercise 13-9 Requirement 1 Cash ....................................................................... 7,500 Liability – customer advance ............................ 7,500 Requirement 2 Cash ....................................................................... 25,500 Liability – refundable deposits ......................... 25,500 Requirement 3 Accounts receivable ............................................... 856,000 Sales revenue .................................................... 800,000 Sales taxes payable ([5% + 2%] x $800,000) ......... 56,000 Exercise 13-10 Normally, 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 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. 19 Exercise 13-11 1. Current liability: $10 million The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year – even if the debt is not expected to be called. 2. Noncurrent liability: $14 million The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt is not yet callable, but will be callable within the year if an existing violation is not corrected within a specified grace period – unless it's probable the violation will be corrected within the grace period. In this case, the existing violation is expected to be corrected within 6 months. 3. Current liability: $7 million The debt should be reported as a current liability because it is payable in the upcoming year, will not be refinanced with long-term obligations, and will not be paid with a bond sinking fund. 20 Exercise 13-12 Requirement 1 This is a loss contingency. There may be a future sacrifice of economic benefits (cost of satisfying the warranty) due to an existing circumstance (the warranted awnings have been sold) that depends on an uncertain future event (customer claims). The liability is probable because product warranties inevitably entail costs. A reasonably accurate estimate of the total liability for a period is possible based on prior experience. So, the contingent liability for the warranty is accrued. The estimated warranty liability is credited and warranty expense is debited in 2006, the period in which the products under warranty are sold. Requirement 2 2006 Sales Accounts receivable ............................................ 5,000,000 Sales ............................................................... 5,000,000 Accrued liability and expense Warranty expense (3% x $5,000,000) ......................... 150,000 Estimated warranty liability ........................... 150,000 Actual expenditures Estimated warranty liability ............................... 37,500 Cash, wages payable, parts and supplies, etc. 37,500 Requirement 3 Warranty Liability _________________________________________ 150,000 Estimated liability Actual expenditures 37,500 112,500 Balance 21 Exercise 13-13 Requirement 1 This is not a loss contingency. An extended warranty is priced and sold separately from the warranted product and therefore essentially constitutes a separate sales transaction. Since the earning process for an extended warranty continues during the contract period, revenue should be recognized over the same period. Revenue from separately priced extended warranty contracts are deferred as a liability at the time of sale, and recognized over the contract period on a straight-line basis. Requirement 2 During 2006 Accounts receivable .............................................. 412,000 Unearned revenue – extended warranties ........ 412,000 December 31, 2006 (adjusting entry) Unearned revenue – extended warranties ............ 103,000 Revenue – extended warranties ([$412,000 ÷ 2 years] x 1/2 year*) ........................ 103,000 * Since sales of warranties were made evenly throughout the year, one-half of one year’s revenue is considered earned. 22 Exercise 13-14 Requirement 1 This is a loss contingency. A liability is accrued if it is both probable that the confirming event will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met, but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the contingency. In this case, a liability is accrued since both of these criteria are met. Requirement 2 Loss: $2 million Requirement 3 Liability: $2 million Requirement 4 Loss – product recall ............................................................... 2,000,000 Liability - product recall .......................................... 2,000,000 A disclosure note also is appropriate. 23 Exercise 13-15 Requirement 1 This is a loss contingency. Some loss contingencies don’t involve liabilities at all. Some contingencies when resolved cause a noncash asset to be impaired, so accruing it means reducing the related asset rather than recording a liability. The most common loss contingency of this type is an uncollectible receivable, as described in this situation. Requirement 2 Bad debt expense: 3% x $2,400,000 = $72,000 Requirement 3 Bad debt expense (3% x $2,400,000) ................................. 72,000 Allowance for uncollectible accounts .................. 72,000 Requirement 4 Allowance for uncollectible accounts: Beginning of 2006 $75,000 Write off of bad debts* 73,000 $ 2,000 Year-end accrual (Req. 3) 72,000 End of 2006 $74,000 * Allowance for uncollectible accounts ........................ 73,000 Accounts receivable .......................................... 73,000 Net realizable value: Accounts receivable $490,000 Less: Allowance for uncollectible accounts (74,000) Net realizable value $416,000 24 Exercise 13-16 Requirement 1 Promotional expense: 70% x $5 x 20,000 = $70,000 Requirement 2 Premium liability: $70,000 – 22,000 = $48,000 Requirement 3 Promotional expense ([70% x $5 x 20,000] – $22,000) ....... 48,000 Estimated premium liability ................................... 48,000 25 Exercise 13-17 Scenario 1 No disclosure is required because an IRS claim is as yet unasserted, and an assessment is not probable. Scenario 2 No disclosure is required because an IRS claim is as yet unasserted, and an assessment is not probable. Even if an unfavorable outcome is thought to be probable in the event of an assessment and the amount is estimable, disclosure is not required unless an unasserted claim is probable. Scenario 3 A disclosure note is required because an IRS claim is as yet unasserted, but an assessment is probable. Since an unfavorable outcome is not thought to be probable in the event of an assessment, no accrual is needed, but since an unfavorable outcome is thought to be reasonably possible in the event of an assessment, disclosure in a footnote is required. Keep in mind, though, that in practice, disclosure of an unasserted claim is rare. Such disclosure would alert the other party, the IRS in this case, of a potential point of contention that may otherwise not surface. The outcome of litigation and any resulting loss are highly uncertain, making difficult the determination of their possibility of occurrence. Scenario 4 Accrual of the loss is required because an IRS claim is as yet unasserted, but an assessment is probable. Since an unfavorable outcome also is thought to be probable in the event of an assessment, accrual is needed. Keep in mind, though, that in practice, accrual of an unasserted claim is rare. Such disclosure would alert the other party, the IRS in this case, of a potential point of contention that may otherwise not surface. Accrual could be offered in court as an admission of responsibility. A loss usually is not recorded until after the ultimate settlement has been reached or negotiations for settlement are substantially completed. 26 Exercise 13-18 Requirement 1 Warranty expense ([4% x $2,000,000] - $30,800) ............. 49,200 Estimated warranty liability .................................. 49,200 Requirement 2 Bad debt expense (2% x $2,000,000) ................................. 40,000 Allowance for uncollectible accounts .................. 40,000 Requirement 3 This is a loss contingency. Classical can use the information occurring after the end of the year and before the financial statements are issued to determine appropriate disclosure. Loss – litigation ......................................................... 1,500,000 Liability - litigation ................................................ 1,500,000 A disclosure note also is appropriate. Requirement 4 This is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. A disclosure note is appropriate. Requirement 5 Loss – product recall ................................................... 500,000 Liability - product recall .......................................... 500,000 A disclosure note also is appropriate. Requirement 6 Promotional expense ([60% x $25 x 10,000] – $105,000) ... 45,000 Estimated premium liability ................................... 45,000 27 Exercise 13-19 1. d 2. d 3. a 4. a Exercise 13-20 Item Reporting Method __C_ 1. Commercial paper. N. Not reported __D_ 2. Noncommitted line of credit. C. Current liability __C_ 3. Customer advances. L. Long-term liability __C_ 4. Estimated warranty cost. D. Disclosure note only __C_ 5. Accounts payable. A. Asset __C_ 6. Long-term bonds that will be callable by the creditor in the upcoming year unless an existing violation is not corrected (there is a reasonable possibility the violation will be corrected within the grace period). __C_ 7. Note due March 3, 2007. __C_ 8. Interest accrued on note, Dec. 31, 2006. __L_ 9. Short-term bank loan to be paid with proceeds of sale of common stock. __D_ 10. A determinable gain that is contingent on a future event that appears extremely likely to occur in three months. __C_ 11. Unasserted assessment of back taxes that probably will be asserted, in which case there would probably be a loss in six months. __N_ 12. Unasserted assessment of back taxes with a reasonable possibility of being asserted, in which case there would probably be a loss in 13 months. __C_ 13. A determinable loss from a past event that is contingent on a future event that appears extremely likely to occur in three months. __A_ 14. Bond sinking fund. __C_ 15. Long-term bonds callable by the creditor in the upcoming year that are not expected to be called. 28 Exercise 13-21 Requirement 1 Accrued liability and expense Warranty expense (3% x $3,600,000) ............................................... 108,000 Estimated warranty liability ............................................... 108,000 Actual expenditures (summary entry) Estimated warranty liability ................................................... 88,000 Cash, wages payable, parts and supplies, etc. .................... 88,000 Requirement 2 Actual expenditures (summary entry) Estimated warranty liability ($50,000 – $23,000) ...................... 27,000 Loss on product warranty (3% – 2%] x $2,500,000) ................... 25,000 Cash, wages payable, parts and supplies, etc. .................... 52,000* *(3% x $2,500,000) – $23,000 = $52,000 29 Exercise 13-22 1. This is a change in estimate. To revise the liability on the basis of the new estimate: Liability - litigation ($1,000,000 – 600,000) ................... 400,000 Gain – litigation ...................................................... 400,000 2. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per-share amounts for the current period. Exercise 13-23 The note describes a loss contingency. Dow anticipates a future sacrifice of economic benefits (cost of remediation and restoration) due to an existing circumstance (environmental violations) that depends on an uncertain future event (requirement to pay claim). Dow considers the liability probable and the amount is reasonably estimable. As a result, the company accrued the liability: ($ in millions) Loss provision from environmental claims ..................... 381 Liability for settlement of environmental claims ... 381 30 Exercise 13-24 1. d. SFAS 43 lists four requirements that must be met before a liability is accrued for future compensated absences. These requirements are that the obligation must arise for past services, the employee rights must vest or accumulate, payment is probable, and the amount can be reasonably estimated. If the amount cannot be reasonably estimated, no liability should be recorded. However, the obligation should be disclosed. 2. c. SFAS 5 requires a contingent liability to be recorded, along with the related loss, when it is probable that an asset has been impaired or a liability has been incurred, and the amount of the loss can be reasonably estimated. The key words are “probable” and “reasonably estimated.” 3. c. SFAS 5 prescribes accounting for contingencies. The likelihood of contingencies is divided into three categories: probable (likely to occur), reasonably possible, and remote. When contingent losses are probable and the amount can be reasonably estimated, the amount of the loss should be charged against income. If the amount cannot be reasonably estimated but the loss is at least reasonably possible, full disclosure should be made, including a statement that an estimate cannot be made. 4. b. If an enterprise intends to refinance short-term obligations on a long-term basis and demonstrates an ability to consummate the refinancing, the obligations should be excluded from current liabilities and classified as noncurrent (SFAS 6, Classification of Short-Term Obligations Expected to Be Refinanced). The ability to consummate the refinancing may be demonstrated by a post-balance-sheet-date issuance of a long-term obligation or equity securities, or by entering into a financing agreement. 31 Exercise 13-25 Salaries and wages expense (total amount earned) ..... 500,000 Withholding taxes payable (federal income tax) .... 100,000 Social security taxes payable ($500,000 x 6.2%) .. 31,000 Medicare taxes payable ($500,000 x 1.45%) ......... 7,250 Salaries and wages payable (net pay) .................. 361,750 Payroll tax expense (total)....................................... 69,250 Social security payable (employer’s matching amount) 31,000 Medicare taxes payable (employer’s matching amount) 7,250 Federal unemployment tax payable ($500,000 x 0.8%) 4,000 State unemployment tax payable ($500,000 x 5.4%) 27,000 32 PROBLEMS Problem 13-1 Requirement 1 Blanton Plastics Cash ......................................................................... 14,000,000 Notes payable ....................................................... 14,000,000 N,C&I Bank Notes receivable ....................................................... 14,000,000 Cash ..................................................................... 14,000,000 Requirement 2 Adjusting entries (December 31, 2006) Blanton Plastics Interest expense ($14,000,000 x 12% x 3/12) ................ 420,000 Interest payable .................................................... 420,000 N,C&I Bank Interest receivable .................................................... 420,000 Interest revenue ($14,000,000 x 12% x 3/12) ............ 420,000 Maturity (January 31, 2007) Blanton Plastics Interest expense ($14,000,000 x 12% x 1/12) ................ 140,000 Interest payable (from adjusting entry) ....................... 420,000 Notes payable (face amount) ...................................... 14,000,000 Cash (total) ............................................................ 14,560,000 N,C&I Bank Cash (total) ................................................................ 14,560,000 Interest revenue ($14,000,000 x 12% x 1/12) ............... 140,000 Interest receivable (from adjusting entry) ................. 420,000 Notes receivable (face amount) ............................... 14,000,000 33 Problem 13-1 (concluded) Requirement 3 Issuance of note (October 1, 2006) Cash (difference) ........................................................ 13,440,000 Discount on notes payable ($14,000,000 x 12% x 4/12)560,000 Notes payable (face amount) ......................................... 14,000,000 Adjusting entry (December 31, 2006) Interest expense ($14,000,000 x 12% x 3/12) ................ 420,000 Discount on notes payable ................................... 420,000 Maturity (January 31, 2007) Interest expense ($14,000,000 x 12% x 1/12) ................ 140,000 Discount on notes payable ................................... 140,000 Notes payable (face amount) ...................................... 14,000,000 Cash ..................................................................... 14,000,000 Effective interest rate: Discount ($14,000,000 x 12% x 4/12) $ 560,000 Cash proceeds ÷ $13,440,000 Interest rate for 4 months 4.1666% x 12/4 ___________ Annual effective rate 12.5% 34 Problem 13-2 Requirement 1 2006 a. No entry is made for a line of credit until a loan actually is made. It would be described in a disclosure note. b. Cash ................................................................... 12,000,000 Notes payable ................................................ 12,000,000 c. Cash .................................................................... 2,600 Liability – refundable deposits ..................... 2,600 d. Accounts receivable (total) .................................. 4,346,000 Sales revenue (given) ...................................... 4,100,000 Sales taxes payable ([3% + 3%] x $4,100,000) ... 246,000 e. Interest expense ($12,000,000 x 10% x 3/12)........... 300,000 Interest payable ............................................. 300,000 2007 f. Cash ................................................................... 10,000,000 Bonds payable ............................................... 10,000,000 Interest expense ($12,000,000 x 10% x 2/12)........... 200,000 Interest payable (from adjusting entry) .................. 300,000 Notes payable (face amount) ................................. 12,000,000 Cash ($12,000,000 + 500,000) ............................ 12,500,000 g. Liability – refundable deposits .......................... 1,300 Cash ............................................................... 1,300 35 Problem 13-2 (concluded) Requirement 2 CURRENT LIABILITIES: Accounts payable $ 252,000 Current portion of bank loan 2,000,000* Liability – refundable deposits 2,600 Sales taxes payable 246,000 Accrued interest payable 300,000 Total current liabilities $2,800,600 LONG-TERM LIABILITIES: Bank loan to be refinanced on a long-term basis $10,000,000* * The intent of management is to refinance all $12,000,000 of the bank loan, but the actual refinancing demonstrates the ability only for $10,000,000. 36 Problem 13-3 Requirement 1 a. The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year – even if the debt is not expected to be called. So, the entire $40 million debt is a current liability. b. $5 million can be reported as long term, but $1 million must be reported as a current liability. Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. The refinancing agreement in this case limits the ability to refinance to $5 million of the notes. In the absence of other evidence of ability to refinance, the remaining $1 million cannot be reported as long term. c. The entire $20 million maturity amount should be reported as a current liability because that amount is payable in the upcoming year and it will not be refinanced with long-term obligations nor paid with a bond sinking fund. d. The entire $12 million loan should be reported as a long-term liability because that amount is payable in 2012 and it will not be refinanced with long-term obligations nor paid with a bond sinking fund. The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt is not yet callable, but will be callable within the year if an existing violation is not corrected within a specified grace period – unless it's probable the violation will be corrected within the grace period. Here, the existing violation is expected to be corrected within 6 months (actually 3 months in this case). 37 Problem 13-3 (concluded) Requirement 2 December 31, 2006 ($ in millions) Current Liabilities Accounts payable and accruals $ 22 10% notes payable due May 2007 1 Currently maturing portion of long-term debt: 11% bonds due October 31, 2017, redeemable on October 31, 2007 $40 12% bonds due September 30, 2007 20 60 Total Current Liabilities 83 Long-Term Debt Currently maturing debt classified as long-term: 10% notes payable due May 2007 (Note X) 5 9% bank loan due October 2009 12 Total Long-Term Liabilities 17 Total Lia NOTE X: CURRENTLY MATURING DEBT CLASSIFIED AS LONG-TERM The Company intends to refinance $6 million of 10% notes that mature in May of 2007. In March, 2007, the Company negotiated a line of credit with a commercial bank for up to $5 million any time during 2007. Any borrowings will mature two years from the date of borrowing. Accordingly, $5 million was reclassified to long-term liabilities. 38 Problem 13-4 Requirement 1 a. Interest expense ($600,000 x 10% x 5/12) ..................... 25,000 Interest payable ................................................ 25,000 b. No adjusting entry since interest has been paid up to December 31. $950,000 can be reported as a noncurrent liability, because (a) intent and (b) ability to refinance has been demonstrated for that amount. c. Accounts receivable (to eliminate the credit balance) ... 18,000 Advances from customers ................................ 18,000 d. Rent revenue (10/12 x $30,000) ................................ 25,000 Unearned rent revenue .................................... 25,000 Requirement 2 CURRENT LIABILITIES: Accounts payable $ 35,000 Current portion of long-term debt250,000 Accrued interest payable 25,000 Advances from customers 18,000 Unearned rent revenue 25,000 Bank notes payable 600,000 Total current liabilities $953,000 LONG-TERM LIABILITIES: Mortgage note payable $950,000 39 Problem 13-5 Requirement 1 B = .10 ($150,000 - B - T), where B = the bonus T = income tax T = .30 ($150,000 - B), Requirement 2 Since income tax (T) is a component of both equations, we can combine the two and then solve for the remaining unknown amount (B): Substitute value of T for T: B = .10 [ $150,000 - B - .30 ($150,000 - B)] Reduce the right-hand side of the equation to one known and one unknown value: B = .10 ( $150,000 - B - $45,000 + .30B) B = .10 ( $105,000 - .70B) B = $10,500 - .07B Add .07B to both sides 1.07B = $10,500 Divide both sides by 1.07 B = $9,813 Requirement 3 Bonus compensation expense ............................. 9,813 Accrued bonus compensation payable ........... 9,813 Requirement 4 The approach is the same in any case: (1) express the bonus formula as one or more algebraic equation(s), (2) use algebra to solve for the amount of the bonus. For example, the bonus might specify that the bonus is 10% of the division’s income before tax, but after the bonus itself: B = .10 ($150,000 - B) B = $15,000 - .10B 1.10B = $15,000 B = $13,636 40 Problem 13-6 a. This is a loss contingency. Eastern can use the information occurring after the end of the year in determining appropriate disclosure. It is unlikely that Eastern would choose to accrue the $122 million loss because the judgment will be appealed and that outcome is uncertain. A disclosure note is appropriate: _______________________________ Note X: Contingency In a lawsuit resulting from a dispute with a supplier, a judgment was rendered against Eastern Corporation in the amount of $107 million plus interest, a total of $122 million at February 3, 2007. Eastern plans to appeal the judgment. While management and legal counsel are presently unable to predict the outcome or to estimate the amount of any liability the company may have with respect to this lawsuit, it is not expected that this matter will have a material adverse effect on the company. b. This is a loss contingency. Eastern can use the information occurring after the end of the year in determining appropriate disclosure. Eastern should accrue the $140 million loss because the ultimate outcome appears settled and the loss is probable. Loss – litigation .......................................... 140,000,000 Liability - litigation ................................. 140,000,000 41 A disclosure note also is appropriate: _________________________________ Notes: Litigation In November 2005, the State of Nevada filed suit against the Company, seeking civil penalties and injunctive relief for violations of environmental laws regulating hazardous waste. On January 12, 2007, the Company announced that it had reached a settlement with state authorities on this matter. Based upon discussions with legal counsel, the Company, has accrued and charged to operations in 2006, $140 million to cover the anticipated cost of all violations. The Company believes that the ultimate settlement of this claim will not have a material adverse effect on the Company's financial position. 42 Problem 13-6 (concluded) c. This is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. Though gain contingencies are not recorded in the accounts, they should be disclosed in notes to the financial statements. _______________________________ Note X: Contingency Eastern is the plaintiff in a pending lawsuit filed against United Steel for damages due to lost profits from rejected contracts and for unpaid receivables. The case is in final appeal. No amount has been accrued in the financial statements for possible collection of any claims in this litigation. d. No disclosure is required because an IRS claim is as yet unasserted, and an assessment is not probable. Even if an unfavorable outcome is thought to be probable in the event of an assessment and the amount is estimable, disclosure is not required unless an unasserted claim is probable. 43 Problem 13-7 Requirement 1 Yes, Northeast’s frequent flyer program is offered in order to enhance revenues. Under the matching principle the cost is properly recognized as an operating expense in the year sales are made (travel miles are earned). Requirement 2 Expense: 25% x $40 million = $10 million Requirement 3 Liability: Beginning of 2006 $25,000 Redemption (8,000) $17,000 Year-end accrual (Req. 2) 10,000 End of 2006 $27,000 Requirement 4 $ in millions Operating expense ............................................. 10 Air traffic liability (25% x $40 million) .............. 10 44 Problem 13-8 Requirement 1 Heinrich would record a contingent liability (and loss) of $27,619,020, calculated as follows: $40,000,000 x 20% = $ 8,000,000 30,000,000 x 50% = 15,000,000 20,000,000 x 30% = 6,000,000 $29,000,000 x .95238* $27,619,020 *Present value of $1, n = 1, i = 5% (from Table 6A-2) Requirement 2 Loss – product recall 27,619,020 Liability – product recall 27,619,020 Requirement 3 The difference between $29,000,000 and the initial value of the liability of $27,619,020 represents interest expense, which Heinrich will accrue during 2007 as follows: Interest expense 1,380,980 Liability – product recall 1,380,980 Requirement 4 Interest increases the liability to $29 million at the end of 2007. Since there is a difference between the actual costs, $30 million, and the $29 million liability, Heinrich will record an additional loss. Liability – product recall 29,000,000 Loss – product recall 1,000,000 Cash 30,000,000 45 Problem 13-9 Case 1 Note Only. When a contingency comes into existence after the year-end, a liability cannot be accrued because it didn’t exist at the end of the year. However, if the loss is probable and can be estimated, the situation should be described in a disclosure note. Case 2 Note Only. Since an unasserted claim or assessment is probable, the likelihood of an unfavorable outcome and the feasibility of estimating a dollar amount should be considered in deciding whether and how to report the possible loss. An estimated loss and contingent liability cannot be accrued since an unfavorable outcome is only reasonably possible even though the amount can be reasonably estimated. Case 3 Accrual and Disclosure Note. When the cause of a loss contingency occurs before the year-end, a clarifying event before financial statements are issued can be used to determine how the contingency is reported. Even though the loss was not probable at year-end, it becomes so before financial statements are issued. The situation also should be described in a disclosure note. Case 4 No Disclosure. Even though the cause of the contingency occurred before year- end, Lincoln is unaware of the loss contingency when the financial statements are issued. 46 Problem 13-10 List A List B j_ 1. Face amount x Interest rate x Time a. Informal agreement g 2. Payable with current assets b. Secured loan h 3. Short-term debt to be refinanced c. Refinancing prior to the issuance with common stock of the financial statements i_ 4. Present value of interest plus d. Accounts payable present value of principal e. Accrued liabilities d 5. Noninterest-bearing f. Commercial paper a 6. Noncommitted line of credit g. Current liabilities b_ 7. Pledged accounts receivable h. Long-term liability c_ 8. Reclassification of debt i. Usual valuation of liabilities f_ 9. Purchased by other corporations j. Interest on debt e_ 10. Expenses not yet paid k. Customer advances l_ 11. Liability until refunded l. Customer deposits k_ 12. Applied against purchase price 47 Problem 13-11 Salaries and wages expense (total amount earned) .......... 2,000,000 Withholding taxes payable (federal income tax) ......... 400,000 Withholding taxes payable (local income tax) ............ 53,000 Social security taxes payable ($2,000,000 x 6.2%) ...... 124,000 Medicare taxes payable ($2,000,000 x 1.45%)............. 29,000 Medical insurance payable ($42,000 x 20%) .............. 8,400 Life insurance payable ($9,000 x 20%) ........................... 1,800 Retirement plan payable (employees’ investment) ......... 84,000 Salaries and wages payable (net pay) ....................... 1,299,800 Payroll tax expense (total) ........................................... 277,000 Social security taxes payable (employer’s matching amount) 124,000 Medicare taxes payable (employer’s matching amount) 29,000 FUTA payable ($2,000,000 x 0.8%) ............................ 16,000 State unemployment tax payable ($2,000,000 x 5.4%) . 108,000 Salaries and wages expense (fringe benefits) ................ 124,800 Medical insurance payable ($42,000 x 80%) .............. 33,600 Life insurance payable ($9,000 x 80%) ........................... 7,200 Retirement plan payable (matching amount) .................. 84,000 48 CASES Research Case 13-1 [Note: This case encourages the student to reference authoritative pronouncements.] The $2,000,000 of commercial paper liquidated in November 2006 would be classified as a current liability in Cheshire's balance sheet at September 30, 2006. The essence of a current liability is that its payment requires the use of current assets or the creation of other current liabilities. If a liability is liquidated after the year-end with current assets, it is reported as a current liability as of the end of the reporting period – even if the current assets are later replenished by proceeds of a long-term obligation before the issuance of the financial statements. The $3,000,000 of commercial paper liquidated in January 2007 but refinanced by the long-term debt offering in December 2006 would be excluded from current liabilities in the balance sheet at the end of September 2006. It should be noted that the existence of a financing agreement at the date of issuance of the financial statements rather than a completed financing at that date would not change these classifications. 49 Real World Case 13-2 Collecting cash from a customer as a refundable deposit normally creates a liability to return the deposit if the deposit is expected to be refunded. In this case, the deposit is not returnable to the customer, but payment still will be made – to the zoo – if the pails are returned. The possible future payment represents a loss contingency to Zoo Doo. A liability is accrued if it is both (a) probable that the pails will be returned and (b) the amount of payment can be reasonably estimated. In that case a liability should be credited (say “Liability – donations for returnable containers”). Since the cost of the containers and the amount of the donation differ, it may be desirable also to employ a receivable account for the cost of containers expected to be returned. To illustrate, assume the sale of 1,000 containers of fertilizer and the expectation that 40% will be returned: When Containers Purchased Inventory (1,000 x $1.76) ................................................ 1,760 Cash .......................................................................... 1,760 When Product Sold Cash .............................................................................. 12,500 Sales (1,000 x $12.50) .................................................. 12,500 Cost of goods sold ($1,760 - [400 x $.76])) ....................... 1,456 Containers receivable ([1,000 x $1.76] x 40%) ................. 704 Inventory (1,000 x $1.76) ............................................. 1,760 Liability – donations for returnable containers ([1,000 x $1.00] x 40%) ............................................... 400 When Containers Returned Inventory (1,000 x 40% x $1.76) ....................................... 704 Liability – donations for returnable containers ............ 400 Containers receivable ................................................ 704 Cash (1,000 x 40% x $1.00) ........................................... 400 When Unreturned Containers Replaced Inventory (600 x $1.76) .................................................. 1,056 Cash .......................................................................... 1,056 50 Case 13-2 (concluded) It is probable that at least some pails will be returned. But this is a start-up company without past experience and there are no other firms with similar operations. So, it is likely that a reasonable estimate cannot be made. [The company president stated this was the case.] If one or both of the accrual criteria is not met, but there is at least a reasonable possibility that the cost will be incurred, a disclosure note should describe the contingency. It also should provide an estimate of the possible loss or range of loss, if possible. If an estimate cannot be made, a statement to that effect is needed. 51 Research Case 13-3 [Note: This case encourages the student to reference authoritative pronouncements.] Paragraph 54 of SFAC No. 6 explains: “Assets are probable future economic benefits owned or controlled by the entity. Its liabilities are claims to the entity's assets by other entities and, once incurred, involve nondiscretionary future sacrifices of assets that must be satisfied on demand, at a specified or determinable date, or on occurrence of a specified event. In contrast, equity is a residual interest – what remains after liabilities are deducted from assets – and depends significantly on the profitability of a business enterprise.” Briefly stated, creditors and owners have claims to a single set of probable future economic benefits owned or controlled by the company. 52 Judgment Case 13-4 Requirement 1 The conditions, all of which must be met for accrual, are: 1. The obligation is attributable to employees' services already performed. 2. The paid absence can be taken in a later year – the benefit vests (will be compensated even if employment is terminated) or the benefit can be accumulated over time 3. Payment is probable. 4. The amount can be reasonably estimated. Requirement 2 a. Military leave, maternity leave, and jury time Custom and practice also influence whether unused rights to paid absences expire or can be carried forward. Obviously, if rights vest (payable even if employment is terminated) they haven’t expired. But typically, absence periods for these types of potential absences do not accumulate if unused, so a liability for those benefits usually is not accrued. Company policy and custom may dictate otherwise, however. An example would be a company policy that permits, say, two weeks paid absence each year for such activities as military leave and jury time, where employees not called to such duty can use the time for leisure activities. If the four accrual conditions are otherwise met, a liability for those benefits should be accrued. b. Paid sabbatical leave An expense and related liability should not be accrued if the sabbatical leave is granted for the benefit of the employer, say for the purpose of new product research. However, if the sabbatical leave is intended to provide unrestricted compensated absence for the last four years’ service and other conditions are met, accrual is appropriate. Company policy, custom, and actual practice should determine proper treatment. c. Sick days If payment of sick pay benefits depends on future illness, an employer does not have to accrue a liability for benefits, even if the four accrual conditions are met. However, the decision of whether to accrue nonvesting sick pay should be based on actual custom and practice. If the employer routinely pays “sick pay” even when absence is not due to illness, a liability for unused sick pay should be recorded. 53 Ethics Case 13-5 Discussion should include these elements. Liabilities had been recorded previously. When a high degree of uncertainty exists concerning the collection of receivables, revenue should not be recorded at the time of sale. Instead, unearned revenue - a liability - should be recorded. With the high degree of uncertainty surrounding “sales” of Outdoors R Us, it would be very hard to justify recording sales revenue when memberships are signed. Ethical Dilemma: How does a doubtful justification for a change in reporting methods compare with the perceived need to maintain profits? Who is affected ? Rice Sun Other managers? The company’s auditor Shareholders Potential shareholders The employees The creditors 54 Trueblood Accounting Case 13-6 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. These are available to instructors at: http://www.deloitte.com/dtt/article/0,1002,sid%3D2257&cid%3D95505,00.html. 55 Communication Case 13-7 Assumptions students make will determine the correct answer to some classifications. Depending on the assumptions made, different views can be convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. A significant benefit of this case is forcing students’ consideration of why liabilities currently due are sometimes classified as long-term. It also requires them to carefully consider the profession’s definition of current liabilities. Arguments likely will include the following: a. Commercial paper If it’s assumed that early April is prior to the actual issuance of the financial statements, then $12 million can be reported as long-term, but $3 million must be reported as a current liability. Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. The refinancing agreement in this case limits the ability to refinance to $12 million of the notes. In the absence of other evidence of ability to refinance, the remaining $3 million cannot be reported as long term. If it’s assumed that early April is after the actual issuance of the financial statements, the ability to refinance has not been demonstrated, and all would be reported as short-term. b. 11% notes Unless it’s assumed that the investments are noncurrent assets, earmarked as a sinking fund for the notes, the debt should be reported as a current liability because it is payable in the upcoming year, will not be refinanced with long-term obligations and will not be paid with a noncurrent asset. 56 Case 13-7 (concluded) c. 10% notes Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements. Management’s ability to refinance at least some of the notes on a long-term basis was demonstrated by the issuance of new bonds prior to the issuance of the financial statements. No mention is made of the proceeds of the new bonds or whether they were used to pay off the maturing notes. If it’s assumed the intent was to refinance the notes, then notes would be classified as noncurrent to the extent of the proceeds of the bonds. d. Bonds If it’s assumed that March 15 is prior to the actual issuance of the financial statements, the bonds can be reported as noncurrent liabilities. The firm (a) intends to refinance on a long-term basis with common stock, and (b) actually has demonstrated the ability to do so by a refinancing agreement prior to the issuance of the financial statements. Refinancing with either debt or equity serves this purpose. 57 Communication Case 13-8 Memorandum: To: Mitch Riley From: Your Name Re: Accounting for contingencies Below is a brief overview of my initial thoughts on how Western should account for the four contingencies in question. 1. The labor disputes constitute a loss contingency. Though a loss is probable, the amount of loss is not reasonably estimable. A disclosure note is appropriate: _______________________________ Note X: Contingency During 2006, the Company experienced labor disputes at three of its plants. The Company hopes an agreement will soon be reached. However negotiations between the Company and the unions have not produced an acceptable settlement and, as a result, strikes are ongoing at these facilities. 2. The A. J. Conner matter is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. Though gain contingencies are not recorded in the accounts, they should be disclosed in notes to the financial statements. _______________________________ Note X: Contingency In accordance with a 2004 contractual agreement with A.J. Conner Company, the Company is entitled to $37 million for certain fees and expense reimbursements. The bankruptcy court has ordered A.J. Conner to pay the Company $23 million immediately upon consummation of a proposed merger with Garner Holding Group. 58 Case 13-8 (concluded) 3. The contingency for warranties should be accrued: Warranty expense ([2% x $2,100 million] – $1 million) 41,000,000 Estimated warranty liability 41,000,000 The liability at December 31, 2006, is reported as $41 million. 4. The Crump Holdings lawsuit is a loss contingency. Even though the lawsuit occurred in 2007, the cause for the action occurred in 2006. Only a disclosure note is needed because an unfavorable outcome is reasonably possible, but not probable. Also, the amount is not reasonably estimable. _______________________________ Note X: Contingency Crump Holdings filed suit in January 2007 against the Company seeking $88 million, as an adjustment to the purchase price in connection with the Company's sale of its textile business in 2006. Crump alleges that the Company misstated the assets and liabilities used to calculate the purchase price for the division. The Company has answered the complaint and intends to vigorously defend the lawsuit. Management believes that the final resolution of the case will not have a material adverse effect on the Company's financial position. We can discuss these further in our meeting later today. 59 Judgment Case 13-9 This is a loss contingency. Valleck can use the information from the February negotiations (occurring after the end of the year) in determining appropriate disclosure. The cause for the suit existed at the end of the year. Valleck should accrue both the $190,000 compliance cost and the $205,000 penalty because an agreement has been reached making the loss probable and the amount at least reasonably estimable. These are the two conditions that require accrual of a loss contingency. The disclosure note should also indicate that accrual was made. This can be accomplished by adding the following sentence to the end of the note: ....... Both of the above amounts have been fully accrued as of December 31, 2006. 60 Communication Case 13-10 Suggested Grading Concepts and Grading Scheme: Content (80% ) 20 Identifies the situation as a change in estimate. The liability was originally (appropriately) estimated as $750,000. The final settlement indicates the estimate should be revised. 40 Describes the journal entry related to the change in amounts. The liability must be reduced (a debit). A gain should be recorded (a credit). The amount of the gain should be $275,000 ($750,000 – $475,000). 20 Indicates that additional disclosure is necessary. Bonus (4) Provides detail regarding the disclosure note. A disclosure note should describe the effect of a change in estimate on key items. The effect on income before extraordinary items, net income, and related per share amounts for the current period should be indicated. 80-84 points Writing (20%) 5 Terminology and tone appropriate to the audience of a Vice President. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 20 points 61 Research Case 13-11 A liability is accrued if it is both probable that a loss will occur and the amount can be at least reasonably estimated. If one or both of these criteria is not met, but there is at least a reasonable possibility that the loss will occur, a disclosure note should describe the nature of the contingency. It also should provide an estimate of the possible loss or range of loss, if possible. If an estimate cannot be made, a statement to that effect is needed. Often such disclosure notes provide only a very general description of contingencies for losses that were not accrued in the financial statements, reducing the usefulness of the information to investors and creditors. 62 Communication Case 13-12 Suggested Grading Concepts and Grading Scheme: Content (80% ) 30 Warranty for awnings (5 each; maximum of 30 for this part) change in estimate change is effected prospectively only no prior financial statements are adjusted will affect the adjusting entry for warranty expense in 2006 [Warranty expense and Estimated warranty liability (2% x $4,000,000)] 30 Clean air lawsuit (5 each; maximum of 30 for this part) change in estimate change is effected prospectively only no prior financial statements are adjusted will require a revision of the previously recorded liability [Loss – litigation and Liability - litigation increased by $150,000 ($350,000 – 200,000)] 20 Indicates that additional disclosure is necessary for both Bonus (4) Provides detail regarding the disclosure note a disclosure note should describe the effect of a change in estimate on key items the effect on income before extraordinary items, net income, and related per-share amounts for the current period should be indicated 80-84 points Writing (20%) 5 Terminology and tone appropriate to the audience of division managers 6 Organization permits ease of understanding introduction that states purpose paragraphs separate main points 9 English word selection spelling grammar 63 Real World Case 13-13 Requirement 1 The frequent flyer program is offered in order to enhance revenues and under the matching principle is properly recognized as an operating expense in the year sales are made (travel miles are earned). Requirement 2 Incremental cost refers to the additional cost of providing the free travel that otherwise would not be incurred. This is the conceptually appropriate measure of the operating expense. Requirement 3 Theoretically, the cost of the portion of the travel to be provided in the coming year should be considered current. Because the awards earned do not expire for several years, presumably, at least a portion of the cost should theoretically be considered long term. Requirement 4 $ in millions Operating expense (given in note) ......................... 215 Air traffic liability ........................................... 215 64 Real World Case 13-14 Requirement 1 The litigation represents a loss contingency. A loss contingency should be accrued if payment is both probable and reasonably estimable. Both criteria were met in this case, necessitating the accrual. Requirement 2 The liability is different for two reasons. First, $30.3 million of the costs were paid in 2004. Second, “estimates were refined and accruals were adjusted accordingly.” Requirement 3 ($ in millions) Remediation liability ($158.1 – 127.5) ............. 30.6 Cash ........................................................... 30.3 Gain - accrual adjustment (to balance) ......... .3 65 Ethics Case 13-15 Discussion should include these elements. Warranty estimate The cost of product warranties (or product guarantees) cannot be predicted with certainty. However, to match expenses and revenues, we estimate the cost. The estimated warranty liability is credited and warranty expense is debited in the reporting period in which the product under warranty is sold. In this case, the estimate is probably “softer” than normal because the company is new and has little experience in these estimates. However, Craig presumably made the estimates on the basis of the best information available. The current effort to change the estimate clearly is motivated by the desire to “window dress” performance. Ethical Dilemma: Is Craig’s obligation to challenge the questionable change in estimates greater than the obligation to the financial interests of his employer and bosses? Who is affected? Craig President, controller, and other managers Shareholders Potential shareholders The employees The creditors The company’s auditors 66 International Case 13-16 The analysis should indicate similarities and differences between the United States and the chosen country focusing on the following issues: a. Depending on the country chosen, the financial statement differences may be minimal. In most countries, current liabilities are reported as a separate classification of liabilities as in the U.S. In other countries, Great Britain, for example, they often are netted against current assets. b. In most countries, like the United States, loss contingencies must be accrued if estimable and probable. Precise meaning of those criteria varies. In a few countries, China, for example, no treatment is specified. In Argentina, gain contingencies are accrued if highly probable, but in most countries they are disclosed only. In several countries, Germany, Italy, and Spain, for instance, they are not disclosed. The analysis might also comment whether cultural differences are likely contributors to the differences observed. 67 Analysis Case 13-17 Requirement 1 Current ratio = Current assets Current liabilities = $1,879 $1,473 = 1.28 Industry average = 1.5 The current ratio is one of the most widely used ratios. It is intended as a measure of short-term solvency and is determined by dividing current assets by current liabilities. Comparing assets that either are cash or will be converted to cash in the near term, with those liabilities that must be satisfied in the near term, provides a useful measure of a company’s liquidity. A ratio of 1 to 1 or higher often is considered a rule-of-thumb standard, but like other ratios, acceptability should be evaluated in the context of the industry in which the company operates and other specific circumstances. IGF’s current ratio is slightly less than the industry average which, on the surface, might indicate a liquidity problem. Keep in mind, though, that industry averages are only one indication of adequacy and that the current ratio is but one indication of liquidity. 68 Case 13-17 (concluded) Requirement 2 Acid-test ratio = Quick assets (or quick ratio) Current liabilities = $48 + 347 + 358 $1,473 = 0.51 Industry average = 0.80 The acid-test or quick ratio attempts to adjust for the implicit assumption of the current ratio that all current assets are equally liquid. This ratio is similar to the current ratio, but is based on a more conservative measure of assets available to pay current liabilities. Specifically, the numerator, quick assets, includes only cash and cash equivalents, short-term investments, and accounts receivable. By eliminating current assets such as inventories and prepaid expenses that are less readily convertible into cash, the acid-test ratio provides a more rigorous indication of a company's short-term solvency than does the current ratio. Once again, IGF’s ratio is less than that of the industry as a whole. Is this confirmation that liquidity is an issue for IGF? Perhaps; perhaps not. It does, though, raise a red flag that suggests caution when assessing other areas. It’s important to remember that each ratio is but one piece of the puzzle. For example, profitability is probably the best long run indication of liquidity. Also, management may be very efficient in managing current assets so that some current assets – receivables or inventory – are more liquid than they otherwise would be and more readily available to satisfy liabilities. 69 Analysis Case 13-18 1. The four components of current liabilities are: ($ in millions) 2004 2003 Current Liabilities: Current portion of long-term debt $ 750 $ 308 Accrued salaries and employee benefits 1,062 724 Accounts payable 1,615 1,168 Accrued expenses 1,305 1,135 Total current liabilities $4,732 $3,335 2. Current assets are sufficient to cover current liabilities in both 2004 and 2003: Total current assets: 2004: $4,970 2003: $3,941 The current ratio for 2004 is: $4,970 ÷ 4,732 = 1.05 The current ratio for 2003 is: $3,941 ÷ 3,335 = 1.18, which is slightly higher. Comparing liabilities that must be satisfied soon with assets that either are cash or will be converted to cash soon provides a useful measure of a company’s liquidity. A current ratio of 1 to 1 or higher sometimes is considered a rule-of- thumb standard. However, the current ratio is but one indication of liquidity. Each ratio is but one piece of the puzzle. 3. From Note 3 we see that the two largest accrued expenses for FedEx in 2004 were employee benefits and insurance expense. An accrued expense is an expense incurred during the current period, but not yet paid. FedEx recorded these as adjusting entries at the end of the reporting period with debits to the appropriate expenses and credits to related liabilities. This helps achieve a proper matching of expenses with the revenues they help generate. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482