978-1259722660 Chapter 13 Lecture Note Part 1

Unlock access to all the studying documents.

View Full Document

CHAPTER 13

CURRENT LIABILITIES AND CONTINGENCIES

Overview

Chapter 13 is the first of five chapters devoted to liabilities. In Part A of this chapter, we discuss

liabilities that are classified appropriately as current. In Part B, we turn our attention to situations in

which there is uncertainty as to whether an obligation really exists. These are designated as loss

contingencies. Some loss contingencies are accrued as liabilities, but others only are disclosed in the

notes.

Learning Objectives

LO13–1 Define liabilities and distinguish between current and long-term liabilities.

LO13–2 Account for the issuance and payment of various forms of notes and record the interest on

the notes.

LO13–3 Characterize accrued liabilities and liabilities from advance collection and describe when

and how they should be recorded.

LO13–4 Determine when a liability can be classified as a noncurrent obligation.

LO13–5 Identify situations that constitute contingencies and the circumstances under which they

should be accrued.

LO13–6 Demonstrate the appropriate accounting treatment for contingencies, including unasserted

claims and assessments.

LO13–7 Discuss the primary differences between U.S. GAAP and IFRS with respect to current

liabilities and contingencies.

Lecture Outline

Part A: Current Liabilities

I. Characteristics of Liabilities

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

enforceable agreements.

B. Some liabilities are not contractual obligations and may not be payable in cash.

C. A liability is a present obligation to sacrifice assets in the future because of something that

already has occurred.

II. What Is a Current Liability?

A. Classifying liabilities as either current or long term helps investors and creditors assess the

relative risk of a business’s liabilities.

B. Current liabilities are expected to require current assets and usually are payable within one

year.

C. Current liabilities ordinarily are reported at their maturity amounts.

1. Practical expediency

2. Conceptually, liabilities should be recorded at their present values.

3. Relatively short time to maturity

Instructors Resource Manual 13-1

McGraw-Hill Education.

III. Open Accounts and Notes

A. Accounts payable and trade notes

1. Accounts payable – buying merchandise on account in the ordinary course of business

creates accounts payable

2. Trade notes payable – formally recognized by a written promissory note; they

sometimes bear interest

B. Short-term notes payable

1. Line of credit – allows a company to borrow cash without having to follow formal loan

procedures and paperwork

2. Interest on notes – face amount × Annual rate × Time to maturity

3. Noninterest-bearing notes – interest is “discounted” from the face amount of a note;

the effective interest rate is higher than the stated discount rate

4. Secured loans – a specified asset (often inventory or accounts receivable) is pledged as

collateral or security for the loan

C. Commercial paper (Exercise 13–5)

1. Large, highly rated firms

2. Lower rate than through a bank loan

3. Unsecured notes sold in minimum denominations of $25,000

4. Maturities ranging from 30 to 270 days

5. Interest often discounted at the issuance of the note

6. Usually backed by a line of credit

7. Recording its issuance and payment exactly the same as forms of notes payable

IV. Accrued Liabilities

A. Represent expenses already incurred but for which cash has yet to be paid (accrued

expenses).

B. Recorded by adjusting entries at the end of the reporting period.

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

payable.

D. An employer accrues an expense and related liability for employees’ compensation for

future absences such as vacation pay if the obligation meets 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. Payment is probable.

4. The amount can be reasonably estimated.

Instructors Resource Manual 13-2

McGraw-Hill Education.

V. Liabilities from Advance Collections

A. Deposits and advances from customers

1. Collecting cash from a customer as a refundable deposit creates a liability to return the

deposit.

2. Collecting cash from a customer as an advance payment for products or services

creates a deferred revenue liability that converts to revenue when the seller satisfies its

performance obligation to deliver products or services.

B. Gift cards are a common example of advanced collection. Record deferred revenue

liability when the card is sold, and then reduce it and recognize revenue if the gift card is

redeemed or the probability of redemption is viewed as remote.

C. Collections for third parties

1. Sales taxes collected from customers represent liabilities until remitted.

2. Payroll-related deductions such as withholding taxes, Social Security taxes, employee

insurance, employee contributions to retirement plans, and union dues (discussed in

the Appendix).

VI. A Closer Look at the Current and Noncurrent Classification

A. Current maturities of long-term debt

1. The currently maturing portion of a long-term debt must be reported as a current

liability.

2. Long-term liabilities that are due on demand—by terms of the contract or violation of

contract covenants—must be reported as current liabilities.

B. Short-term obligations can be reported as noncurrent liabilities if the company:

1. Intends to refinance on a long-term basis and

2. Demonstrates the ability to do so by a refinancing agreement or by actual financing.

a. Under U.S. GAAP, liabilities payable within the coming year are classified as

long-term liabilities if refinancing is completed before date of issuance of the

financial statements. Under IFRS, refinancing must be completed before the

balance sheet date. The FASB is considering an exposure draft proposing the

IFRS method.

Part B: Contingencies

I. Loss Contingencies

A. Involves an existing uncertainty as to whether a loss really exists, where the uncertainty

will be resolved only when some future event occurs.

B. Accrued only if a loss is:

1. Probable and

2. The amount can reasonably be estimated.

C. The contingent liability for product warranties almost always is accrued. (Exercise 13–17)

D. The contingent liability for premiums (like cash rebates) almost always is accrued.

E. 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.

F. Unasserted claims and assessments

1. It must be probable that an unasserted claim or assessment or an unfiled lawsuit will

occur before considering whether and how to report the possible loss.

a. Is a claim or assessment probable? (If not, no disclosure is needed.)

Instructors Resource Manual 13-3

McGraw-Hill Education.

b. Only if a claim or assessment is probable should we evaluate (a) the likelihood of

an unfavorable outcome and (b) whether the dollar amount can be estimated,

accruing and disclosing under the same circumstances we would use for a claim

that had already been asserted.

2. If the conclusion of Step 1 is that the claim or assessment is not probable, no further

action is required.

G. Overall, accounting for contingent losses under IFRS is quite similar to accounting under

U.S. GAAP. However, there are some important differences:

1. IFRS refers to accrued liabilities as “provisions,” and refers to possible obligations

that are not accrued as “contingent liabilities.” The term “contingent liabilities” is

used for all of these obligations in U.S. GAAP.

2. IFRS requires disclosure (but not accrual) of two types of contingent liabilities: (1)

possible obligations whose existence will be confirmed by some uncertain future

events that the company does not control, and (2) a present obligation for which

either it is not probable that a future outflow will occur or the amount of the future

outflow cannot be measured with sufficient reliability. U.S. GAAP does not make this

distinction but typically would require disclosure of the same contingencies.

3. IFRS defines “probable” as “more likely than not” (greater than 50%), which is a

lower threshold than typically associated with “probable” in U.S. GAAP.

4. If a liability is accrued, IFRS measures the liability as the best estimate of the

expenditure required to settle the present obligation. If there is a range of equally

likely outcomes, IFRS would use the midpoint of the range, while U.S. GAAP

requires use of the low end of the range.

5. If the effect of the time value of money is material, IFRS requires the liability to be

stated at present value. U.S. GAAP allows using present values under some

circumstances, but liabilities for loss contingencies like litigation typically are not

discounted for time value of money.

6. IFRS recognizes provisions and contingencies for “onerous” contracts, defined as

those in which the unavoidable costs of meeting the obligations exceed the expected

benefits. Under U.S. GAAP we generally don’t disclose or recognize losses on such

money-losing contracts, although there are some exceptions (for example, losses on

long-term construction contracts are accrued, as are losses on contracts that have been

terminated).

II. Gain Contingencies

A. Gain contingencies are not accrued.

1. Under IFRS, gain contingencies are accrued if their future realization is “virtually

certain” to occur. Under U.S. GAAP, gain contingencies are never accrued.

B. Conservatism

Decision Makers’ Perspective

A. Current liabilities impact a company’s liquidity.

B. Liquidity refers to a company’s cash position and overall ability to obtain cash in the

normal course of business.

C. It’s critical that managers as well as outside investors and creditors maintain close scrutiny

of a company’s liquidity.

Instructors Resource Manual 13-4

McGraw-Hill Education.

D. The current ratio is a measure of short-term solvency.

1. Determined by dividing current assets by current liabilities.

2. Should be evaluated in the context of the industry in which the company operates and

other specific circumstances.

3. But one indication of liquidity.

4. Acid-test or quick ratio, by eliminating current assets such as inventories and prepaid

expenses that are less readily convertible into cash, provides a more rigorous

indication of a company’s short-term solvency.

E. Outside analysts as well as managers should actively monitor risk management activities.

Appendix 13: Payroll-Related Liabilities

A. Employers are required by law to withhold federal (and sometimes state) income taxes and

Social Security taxes from employees’ paychecks and remit these to the IRS.

1. Also, the Federal Insurance Contributions Act requires employers to withhold a

percentage of each employee’s earnings up to a specified maximum.

B. Besides the required deductions for income taxes and Social Security taxes, employees

often authorize their employers to deduct other amounts from the paychecks, such as

union dues, contributions to savings or retirement plans, and insurance premiums.

C. The employer also must pay federal and state unemployment taxes on behalf of its

employees.

D. In addition to salaries and wages, withholding taxes, and payroll taxes, many companies

provide employees a variety of fringe benefits. Most commonly, employers pay all or part

of employees’ insurance premiums and/or contributions to retirement income plans.

PowerPoint Slides

Two PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

Instructors Resource Manual 13-5

McGraw-Hill Education.

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter,

but they can be easily edited to allow instructors to change numbers and content

in illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

Suggestions for Class Activities

1. Business Scenario

Outpost Healthcare, Inc., provides long-term health care services primarily through the operation

of nursing centers and hospitals. It operates 380 nursing centers, with 45,627 licensed beds in 35

states, and a rehabilitation therapy business. The following news release appeared in March 2018.

OUTPOST HEALTHCARE ANNOUNCES FISCAL 2017 RESULTS

Company Provides Operating Guidance for Fiscal 2018

Hall, Ind. (March 5, 2018) – Outpost Healthcare, Inc., (the “Company”) (NASDAQ: OUTP) today

announced its operating results for the fourth quarter and fiscal year ended December 31, 2017.

Revenues for the fourth quarter of 2017 grew 7% to $689 million compared to $644 million in the

fourth quarter last year, and net income from operations for the current quarter totaled $15.1 million

or $0.74 per diluted share. Operating results for the fourth quarter of 2017 included an unusual

pretax gain of $3.1 million ($2.3 million net of tax or $0.06 per diluted share) recorded in connection

with the resolution of a loss contingency related to a partnership interest.

Suggestions:

Have the class consider how Outpost might have recorded a gain “in connection with the

resolution of a loss contingency.” What might have led to the loss contingency being recorded? How

did they record it? How would the gain be recorded?

Points to Note:

Apparently a previously recorded loss was higher than the ultimate outcome. Such situations are

treated as changes in estimates. That is, no adjustment is made to the original reporting. Instead,

Instructors Resource Manual 13-6

McGraw-Hill Education.

when the estimate turns out to be wrong, a gain is recorded for the overstatement of the loss. Outpost

apparently had felt the loss contingency was both probable and reasonably estimable. The loss

contingency would have been accrued with a debit to a loss and a credit to a liability. The subsequent

gain would be offset with a debit to the liability.

Instructors Resource Manual 13-7

McGraw-Hill Education.

2. Real World Scenario

The following

represents a portion of an actual press release:

Mon Aug 10, 2009 6:12 pm EDT

WARRENVILLE, Ill. -(Business Wire)-

Fuel Tech, Inc. (NASDAQ: FTEK), a world leader in advanced engineering solutions for

optimization of combustion systems and emissions control in utility and industrial applications,

today reported results for the three- and six-month periods ended June 30, 2009.

Second-Quarter 2009

…The Air Pollution Control technology segment (APC segment) generated revenues of $9.2 million,

a decrease of 12% versus the second quarter of 2008. This segment continues to feel the effects of

deferred capital investment by electric utilities and other industrial customers as the combination of

an economic slowdown, reduced electricity demand, shortfalls in cash generation by power

providers and ongoing uncertainty over the ultimate outcome of the Clean Air Interstate Rule

(CAIR) served to depress outlays for NOx control systems. Segment gross margins were 49% versus

the 46% reported in the second quarter of 2008. Contributing to the increase was a partial reversal of

the first-quarter 2009 contingent loss provision on an APC contract, which has now been resolved.

Suggestions:

Have the class consider the effect of the loss contingency. What motivated Fuel Tech to reverse

the loss contingency? (Resolution of the contingency at a reduced amount.) How did they record it?

(Reversed part of the prior accrual entry.) Is there any potential for earnings management with loss

contingencies? (Yes, if over accrue in a very good or very bad period, can reverse that later to benefit

income in a future period.)

Instructors Resource Manual 13-8

McGraw-Hill Education.

Fuel Tech Reports Second-Quarter 2009 Results

3. PetSmart Analysis

Have students, individually or in groups, go to the most recent PetSmart annual report at PetSmart’s

website: www.petsmart.com. Ask them to:

1. Compare accounts payable, accrued expenses, and other current liabilities with those in the

annual report that came with the textbook. Are there any discernible trends? How might they

be interpreted?

2. Determine what contingencies are reported in the disclosure notes. Are any accrued?

3. Read “Management’s Discussion and Analysis of Results of Financial Condition and Results of

Operations” and determine management‘s view of PetSmart’s current liquidity.

4. Professional Skills Development Activities

The following are suggested assignments from the end-of-chapter material that will help your

students develop their communication, research, analysis, and judgment skills.

Communication Skills. In addition to Communication Cases 13–7, 13–8, 13–10, and 13–12,

Judgment Case 13–9 can be adapted to ask students to write a memo to the “veteran board

member.” Real World Case 13–13 and IFRS Case 13–14 are suitable for student

presentation(s). Communication Case 13–7, Real World Case 13–2 and Analysis Case 13–17

do well as group assignments. Ethics Case 13–5 and Trueblood Case 13–6 create good class

discussions.

Research Skills. In their professional lives, our graduates will be required to locate and extract

relevant information from available resource material to determine the correct accounting

practice, perhaps identifying the appropriate authoritative literature to support a decision using

the FASB’s Accounting Standards Codification. Exercises 13–10 and 13–14 and Research

Cases 13–1, 13–3, 13–6, and 13–11 provide an excellent opportunity to help students develop

this skill.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct

students to gather, assemble, organize, process, or interpret date to provide options for making

business and investment decisions. In addition to Analysis Cases 13–16 and 13–17, Exercise

13–7, Problems 13–8 and 13–9, and Real World Cases 13–2 and 13–13 also provide

opportunities to develop analysis skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require

students to critically analyze issues to apply concepts learned to business situations in order to

evaluate options for decision making and provide an appropriate conclusion. In addition to

Judgment Cases 13–4 and 13–9, Ethics Case 13–5 and Trueblood Case 13–6 also require

students to exercise judgment.

Instructors Resource Manual 13-9

McGraw-Hill Education.

Instructors Resource Manual 13-10

McGraw-Hill Education.