Chapter Twelve
Current Liabilities and
Contingencies
Current Liabilities
• Economic obligations that are expected to be
liquidated using current assets or refinanced by
other current liabilities during the normal
operating cycle, or within one year of the
balance sheet date, whichever is longer
•
•
•
•
•
Accounts payable
Notes payable within one year
Dividends payable
Advances from customers or collections
Accrual for salaries, wages, commissions, rents
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Accrued Liabilities
• Record expenses that have been incurred but
not yet paid (accruals)
• Salaries
• Taxes
• Interest
• At year end, record the accrual for any unpaid
expenses. Assume you have received a utility
bill for $250, but have not yet paid it:
Utilities Expense
Utilities Payable
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Deferred Liabilities
• Adjust for amounts that have been received but
have not been earned as of the end of the
period (deferrals or unearned income)
• Advances from customers
• Refundable deposits
• When advance payment is received:
Cash
Deferred Revenue (or Unearned Income)
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• At year end, record amount earned:
Deferred Revenue (or Unearned Income)
Income (or Revenue)
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Employee-Related Liabilities
• Amounts owed to
employees or other
entities at the balance
sheet date, but not
yet paid
• Reflected as current
liabilities
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• Wages and salaries
• Payroll deductions for
taxes, insurance, or
union dues
• Bonuses
• Compensated
absences
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Compensated Absences
• Vacation and sick pay that are expected to be
paid out in future periods
• The employer is expected to accrue a liability for
compensated absences if all of these conditions
are met:
• Employee has rendered service required to earn the
benefits.
• The obligation relates to rights that accumulate or
vest.
• Payment of compensation is probable.
• Amount of liability can be reasonably estimated.
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Calculating Vacation Pay Accruals
• Illustration: Assume that Nichols Co. has 50 employees
during 2005. Each employee earns 10 days of vacation pay
per year. Assume that each employee’s salary rate during
2005 is $100 per day and vacation days can accumulate and
be used in future years.
• Accrue vacation pay at December 31, 2005
Payroll Expense (50 x 10 x $100)
Vacation Payable
50,000
50,000
• Ten employees use all vacation days in 2005. When
they are paid their vacation pay, record this entry:
Vacation Payable (10 x 10 x $100)
Cash
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10,000
10,000
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Calculating Vacation Pay
Accruals (continued)
• Illustration continued: Assume that the
other 40 employees use all vacation pay
in 2006, when the salary rate is $105 per
day. When the vacation is taken, record
this entry:
Vacation Payable (40 x 10 x $100)
Payroll Expense (40 x 10 x $5)
Cash (40 x 10 x $105)
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40,000
2,000
42,000
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Calculating Sick Pay Accruals
• If sick pay vests (employee can be paid for
unused days when he or she leaves the
company), then sick pay must be accrued.
• If sick pay does not vest, no accrual is required.
Sick pay is conceptually different from vacation
pay since sick pay is dependent on a future event
(illness). Vacation pay is earned as a result of past
service.
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Short-Term Obligations to Be
Refinanced
• Loans or obligations
• Example: ABC Co.
that are due within
has a loan due 1 year
one year but that may
from balance sheet
not be paid off with
date. The loan is part
current assets when
of a revolving credit
due
arrangement. Thus,
• Obligation expected
ABC can refinance
to be refinanced can
the loan when it
be excluded from
becomes due.
short-term liabilities if
intent and ability to
refinance are present.
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Demonstrating the Ability to
Refinance
1. If a company issues
a long-term
obligation or equity
securities after the
balance sheet date
but before the
statements are
issued, it has
demonstrated the
ability to refinance.
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2. If a company signs a
financing agreement
before the balance
sheet date that
clearly permits the
refinancing of the
short-term debt, the
company has
demonstrated the
ability to refinance.
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Contingencies
• An existing situation, condition, or set of
circumstances involving uncertainty that will be
resolved when one or more future events occur
1. As of the balance
sheet date, an event
must have occurred
or a condition must
be in existence.
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2. The outcome of that
event or condition
must be dependent
upon a future event.
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Examples of Contingencies
• Lawsuit filed but not settled
• Collectibility of receivables
• Obligations for product warranties or
guarantees
• Threat of expropriation of assets
• Pending or threatened litigation
• Guarantees of the indebtedness of others
• Actual or possible assessments or claims
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Contingency Issues
to Consider
•
If a contingency exists:
1. Should the company recognize an amount
as a liability?
2. How likely is the potential of a loss?
3. How much should be recognized as a
liability?
4. How should a loss contingency be
disclosed?
5. Are gain contingencies recorded?
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Loss Contingencies
•
•
Existing circumstances involving a potential
loss that hinges on some future event
If a contingent item is both a loss contingency
and is material, a liability should be accrued if:
1. The loss is probable.
2. The amount can be reasonably estimated.
Requires accountants to exercise professional judgment
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Disclosure of Loss
Contingencies
• If contingency
is probable…
Accrue as a liability, disclose
details in notes to financials
• If contingency is
reasonably
possible…
Do not accrue as a liability,
but disclose in notes to the
financials
• If contingency is
remote…
Do not accrue as a liability
or disclose in notes
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Warranties
• An implied or expressed promise by the
seller to compensate the buyer for a
deficiency in the product
• Usually involve a promise to replace or
repair the product if deficient; or may
involve a promise to pay a certain dollar
amount
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Warranty Liabilities
• If amount of liability can be reasonably
estimated at the time of the sale, report as
follows:
Current liabilities: Any portion of the liability expected
to be paid within one year of the balance sheet date
Long-term liabilities: Remainder of liability not
expected to be paid in one year
• When the credit entry is made to record the
liability, the debit is normally made to an
expense account.
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Warranty Liabilities Illustrated
• Illustration: Assume that BigCar Co. sells 100 cars for
$30,000 each during 2005. Each car has a warranty that
covers repairs for the first three years or 36,000 miles.
Based on past history, the company estimates that
repairs are 2 percent of sales. Record the following
warranty liability for 2005:
Warranty Expense ($3,000,000 x 0.02)
Warranty Liability
60,000
60,000
• Assume that during 2005, repair costs on current-year
sales were $26,000. The costs should be recorded:
Warranty Liability
Cash, Parts Inventory, or A/P
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26,000
26,000
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Cash Warranty Liabilities
Illustrated
• Illustration: Assume that BigCar Co. sells 50 extended
warranties in 2005 for $1,000 each. The warranty covers
repairs for two years after the basic three-year
warranty/36,000-mile warranty has expired. Record the
sale as follows:
Cash
50,000
Extended Warranty Liability
50,000
• At year end 2008, $20,000 of repair costs were incurred
under the extended warranty agreements. BigCar should
record:
Warranty Expense
20,000
Cash, Parts Inventory, or A/P
20,000
Extended Warranty Liability ($50,000 x ½)
Warranty Revenue
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25,000
25,000
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Premium or Coupon Offers
• Premium or coupon offers represent the
creation of a contingent liability
• If a company sells products that include a
coupon to purchase other products at a
discount, the company has an obligation to sell
to the customer at a discounted price. At year
end, the company must estimate the number of
coupons that will be redeemed and the cost of
the product to be sold to establish the liability.
Expense for Coupons to Be Redeemed
Estimated Liability for Coupons
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Gain Contingencies
• Uncertain situations that may result in a
claim to an asset or a reduction in a
liability
• Gain contingencies should not be
recorded because revenue should not be
recognized prior to its realization.
• Evidence of the conservatism principle in
accounting
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Liquidity Analysis and
Current Liabilities
Working Capital =
Total Assets – Total
Liabilities
Identifies the amount of
current assets
available to continue
business operations
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Current Ratio =
Current Assets  Current
Liabilities
Identifies how well a
company is able to meet
its current obligations
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Window Dressing
• Refers to inappropriate actions taken by
management at the end of an accounting
period to make the company’s financial
ratios appear more favorable than they
actually are.
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Cash Flow and Current
Liabilities
• Most current liabilities are related to operating
activities
• When determining actual cash flows for current
liabilities, examine the balances of all current
liability accounts
• An increase in a current
liability account indicates
that less cash was paid
and should be deducted
on the statement of cash
flows
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• A decrease in a current
liability account indicates
that more cash was paid
and should be added on
the statement of cash
flows
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Check Your Understanding
Q What journal entry is generally made
when cash is received in advance but has
not yet been earned?
A Debit Cash; Credit Deferred Revenue (or
Unearned Income)
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Check Your Understanding
Q When a company carries a short-term
loan that it expects to refinance, how does
it demonstrate the ability to refinance?
A (1) By issuing a long-term obligation or
equity securities to replace the current
debt after the balance sheet date but
before the issuance of the financial
statements, or (2) By signing a financing
agreement before the balance sheet date
that permits the refinancing.
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Check Your Understanding
Q If a contingent loss is probable and can be
reasonably estimated, how should it be
recorded and/or disclosed?
A The contingent loss should be reported as
a liability, and the details of the liability
should be disclosed in the notes to the
financial statements.
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Check Your Understanding
Q How are gain contingencies accounted
for?
A Gain contingencies should not be
recorded because revenue should not be
recognized prior to its realization.
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Check Your Understanding
Q What journal entry is generally made to
record product warranties included in
product sales?
A If the amount can be reasonably
estimated, debit Warranty Expense and
credit Warranty Liability
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Check Your Understanding
Q What is window dressing in relation to
financial statement presentation?
A Window dressing refers to inappropriate
financial actions taken by management at
the end of a fiscal period to make the
financial ratios appear more favorable.
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Check Your Understanding
Q How would an increase in a current
liability account be treated on the
statement of cash flows using the indirect
method?
A An increase in a current liability account
indicates that less cash was paid and
should thus be deducted on the statement
of cash flows.
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Check Your Understanding
Q Are current liabilities generally related to
operating, financing or investing activities?
A Current liabilities are most often related to
operating activities.
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