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Chapter 10

Introduction to Liabilities: Economic Consequences, Current Liabilities

and Contingencies

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Liabilities

What is a liability?– “Probable future sacrifice of economic benefits

arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”

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Liabilities

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Reporting Liabilities on the Balance Sheet: Reporting Liabilities on the Balance Sheet: Economic ConsequencesEconomic Consequences

Shareholders and investors– interest expense is tax deductible, but more debt means

more risk to shareholders– equity ownership is subordinated to creditors

Creditors– restrictive covenants regarding debt limits

Management– wants to minimize debt on the balance sheet– often looks for “off-balance sheet” financing– less debt now improves ability to borrow in the future

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Current Liabilities

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Current LiabilitiesCurrent Liabilities Classification

– expected to require the use of current assets (or the creation of other current liabilities) to settle the obligation.

Valuing current liabilities on the balance sheet– Ignore present value (report at face value)

Reporting current liabilities– Primary problem is ensuring that all existing current

liabilities are reported on the balance sheet.

Figure 10-3Figure 10-3

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Determinable Current LiabilitiesDeterminable Current Liabilities

1. Accounts payable (Ch 7)

2. Short-term notes

3. Current maturities of long-term debts

4. Dividends payable

5. Unearned revenues (Ch 5)

6. Sales tax payable

7. Income taxes payable (App 10B)

8. Payroll taxes payable

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Determinable CL - continuedDeterminable CL - continued Accrued liabilities - accrue expense and liability at

the end of the current period, and usually paid sometime during the next year. For each item, debit expense and credit liability. Examples include:– Wages payable– Salary payable– Interest payable– Rent payable– Insurance payable– Property taxes payable– Employee bonuses

Incentive CompensationIncentive Compensation

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Contingent LiabilitiesContingent Liabilities

Contingent on some future event or activity in order to know the exact amount. Examples: warranties, coupons and lawsuits

Changes in estimate may be made in subsequent periods, when future event is concluded.

Under IFRS, much of these transactions are reported in a balance sheet account called “provisions”.–Provisions are more readily booked than contingent liabilities because IFRS provisions are accrued when the obligation is “more likely than not,” while under US GAAP contingent liabilities are accrued when “highly probable,” which is a much higher threshold.

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Figure 10-5Figure 10-5

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Contingent Liabilities Contingent Liabilities Warranties

– Uncertain future costs– Record estimated expense and liability when products

are sold (matching concept):

Warranty Expense xx

Estimated Warranty Liability xx

– As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability:

Estimated Warranty Liability xx

Cash, etc. xx

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Class Problem: P10-4, Parts a & b:Class Problem: P10-4, Parts a & b:

Issues and recommendations:- Likelihood?

Probable - Disclose?

Yes - Disclosure?

Indicate range and level of probability(250,000 – 1.5 million)

- Accrue? Since probable (or greater) and

estimable, accrual is required, based on best estimate.

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Class Problem: P10-4, Part c:Class Problem: P10-4, Part c:Adjusting journal entry for 2011:

Estimated loss 742,000

Estimated liability 742,000

(Best guess in the range)

Journal entry at settlement (8/12/12):

Estimated liability 742,000

Recovery of estimated loss 52,000

Cash 690,000

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WarrantyWarrantyA promise by a manufacturer or seller to ensure A promise by a manufacturer or seller to ensure the quality or performance of the product for a the quality or performance of the product for a

specific period of timespecific period of time

Almost Honest

JOHN’SUsed Cars

I’ll stand behind itfor 50 miles

or 50 minuteswhichever comes first

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Class Exercise: E10-10(a)Class Exercise: E10-10(a)(1) GJE to record sale in 2011 (200 @ $250 each):

Cash 50,000Sales revenue 50,000

(2) AJE in 2011 to record estimated warranty for the sales (200 @ $20):

Warranty expense 4,000Estimated Warr. Liability 4,000

(3) GJE to record payment in 2011 for repairs:Est. Warr. Liability 1,400

Cash 1,400 GJE to record payment in 2012 for repairs:

Est. Warr. Liability 2,600Cash 2,600

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Class Exercise: E10-10(b)Class Exercise: E10-10(b)Income effects for the revenue and warranty expense under the two alternative for recognition of expense (expressed in thousands):

Accrue Expense Expense as Paid 2011 2012 2011 2012

Revenues 50,000 --- 50,000 ---Warr. Expense (4,000) --- (1,400) (2,600)

Note that the accrual method recognizes the expense in the same period as the revenues generated by the sale.

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Retirement Costs (App 10A)Retirement Costs (App 10A) Defined Contribution Plans

– Less expensive than Defined Benefit Plans– 401(k), 403(b), 457– The entry to record period contributions is very

simple:Dr. Pension Expense

Cr. Cash Defined Benefit Plans

– Benefits must be predicted, therefore several assumptions and estimates are required

– Social Security is form of Defined Benefit Plan– The entry to record the estimated liability is simple, but

the calculations can be quite complicated:Dr. Pension Expense

Cr. Pension Liability

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Deferred Taxes (App 10B)Deferred Taxes (App 10B) Generated by the discrepancy between income and

expenses for taxation (specified by IRS) and financial reporting (specified by GAAP).

Example:– Equipment purchased on 1/1/09 for $9,000– 3-year useful life– no salvage value– DDB for income tax purposes– SL for financial reporting purposes– Income tax rate of 30%

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Depreciation SchedulesDepreciation Schedules

2009 Deferred income tax liability $900

2010 Deferred income tax benefit $300

2011 Deferred income tax benefit $600

Year DDB SL Diff Rate Tax Benefit(Disbenefit)

2009 $6000 - 3000 = $3000 X 30% = $900

2010 2000 - 3000 = (1000) X 30% = (300)

2011 1000 - 3000 = (2000) X 30% = (600)

Total $9000 $9000 $0 $0

Deferred Income Tax LiabilityDeferred Income Tax Liability

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The Conservatism RatioThe Conservatism Ratio

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The Conservatism RatioThe Conservatism Ratio

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CopyrightCopyright

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