Chapter 13 Current Liabilities and Conti PDF

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Chapter 13

Current Liabilities and Contingencies

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills: Questions

AACSB Tag

Brief Exercises

AACSB Tag

13–1 13–2 13–3 13–4 13–5 13–6 13–7 13–8 13–9 13–10 13–11 13–12 13–13 13–14 13–15 13–16 13–17 13–18 13–19 13–20 13–21 13–22 13–23 13–24 13–25 13–26 13–27 13–28

Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking

13–12 13–13 13–14 13–15 13–16 13–17 13–18 13–19 13–20

Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic

Brief Exercises 13–1 13–2 13–3 13–4 13–5 13–6 13–7 13–8 13–9 13–10 13–11

Solutions Manual, Vol.2, Chapter 13

Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic

Exercises 13–1 13–2 13–3 13–4 13–5 13–6 13–7 13–8 13–9 13–10 13–11 13–12 13–13 13–14 13–15 13–16 13–17 13–18 13–19 13–20 13–21 13–22 13–23 13–24 13–25 13–26 13–27

Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Communications Analytic Analytic Analytic Communications Analytic, Reflective thinking Analytic Analytic, Reflective thinking Analytic, Communications Analytic Reflective thinking Analytic Analytic, Reflective thinking Reflective thinking Analytic Analytic Analytic Analytic

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Analytic Analytic

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Analytic Analytic Analytic Analytic Diversity, Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking

Problems 13–1 13–2 13–3 13–4 13–5 13–6 13–7 13–8 13–9 13–10 13–11 13–12 13–13

Analytic Analytic Analytic Analytic Analytic Analytic Analytic, Reflective thinking Analytic Analytic Analytic Reflective thinking Analytic, Communications Analytic

© The McGraw-Hill Companies, Inc., 2013 13–2

Intermediate Accounting, 7e

QUESTIONS FOR REVIEW OF KEY TOPICS Question 13–1 A liability involves the past, the present, and the future. 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. 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. [FASB ASC 835–30–15–3: “Interest–Imputation of Interest–Scope and Scope Exceptions (previously “Interest on Receivables and Payables,” Accounting Principles Board Opinion No 21, (New York, AICPA, August 1971, Par. 3))] specifically exempts from present value valuation all liabilities arising in connection with suppliers in the normal course of business and due within a year.

Solutions Manual, Vol.2, Chapter 13

© The McGraw-Hill Companies, Inc., 2013 13–3

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. Noninterest-bearing notes 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. he expense and related liability should be recorded as follows: Salaries expense Salaries payable

5,000 5,000

This achieves a proper matching of this expense with the revenues it helps generate, and recognizes that a liability has been created by the employee earning wages for which she has not yet been paid.

© The McGraw-Hill Companies, Inc., 2013 13–4

Intermediate Accounting, 7e

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 from mandatory accrual, according to GAAP regarding compensated absences, 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 Gift cards are a particular form of advance collection of revenues. When the payment is received, the seller debits cash and credits an unearned revenue liability. Later, unearned revenue is reduced and revenue recognized either when the customer redeems the gift card or when the probability of redemption is viewed as remote, based on an expiration date or the company’s experience.

Question 13–11 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.

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© The McGraw-Hill Companies, Inc., 2013 13–5

Answers to Questions (continued) Question 13–12 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.

Question 13–13 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 13–14 Under U.S. GAAP, ability to finance must be demonstrated by securing financing prior to the date the balance sheet is issued; under IFRS, ability to finance must be demonstrated by securing financing prior to the balance sheet date (which typically is a couple of months earlier than the date of issuance).

Question 13–15 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) a possible repair to a product under warranty, (2) a possible uncollectible receivable, (3) being the defendant in a lawsuit.

Question 13–16 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 13–17 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 McGraw-Hill Companies, Inc., 2013 13–6

Intermediate Accounting, 7e

Answers to Questions (continued) Question 13–18 Under U.S. GAAP, the term “contingent liability” is used to refer generally to contingent losses, regardless of probability. Under IFRS, a contingent liability refers only to those contingencies that are not recognized in the financial statements; the term “provision” is used to refer to those that are accrued as liabilities because they are probable and reasonably estimable.

Question 13–19 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.

Question 13–20 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 13–21 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 13–22 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.

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© The McGraw-Hill Companies, Inc., 2013 13–7

Answers to Questions (concluded) Question 13–23 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).

Question 13–24 In U.S. GAAP, the low end of the range is accrued as a liability, and the rest of the range is disclosed. In IFRS, the mid-point of the range is accrued.

Question 13–25 In IFRS, present values must be used to measure a liability whenever the time value of money is material. That requirement does not exist for U.S. GAAP.

Question 13–26 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, note 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 13–27 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."

Question 13–28 You should accrue your gain. Under IFRS, a gain contingency is accrued if it is virtually certain to occur, as is the case with respect to this gain.

© The McGraw-Hill Companies, Inc., 2013 13–8

Intermediate Accounting, 7e

BRIEF EXERCISES Brief Exercise 13–1 Cash ............................................................... Notes payable ..............................................

60,000,000

Interest expense ($60,000,000 x 12% x 3/12) ........ Interest payable ..........................................

1,800,000

60,000,000 1,800,000

Brief Exercise 13–2 Cash (difference) .......................................................... Discount on notes payable ($60,000,000 x 12% x 9/12)... Notes payable (face amount) .................................... Interest expense ($60,000,000 x 12% x 3/12)................... Discount on notes payable ....................................

54,600,000 5,400,000 60,000,000 1,800,000 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

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Brief Exercise 13–4 Cash (difference) .......................................................... Discount on notes payable ($12,000,000 x 9% x 9/12)..... Notes payable (face amount) ....................................

11,190,000 810,000 12,000,000

Interest expense ........................................................ Discount on notes payable ...........................................

810,000

Notes payable (face amount) ........................................ Cash .......................................................................

12,000,000

810,000

12,000,000

Brief Exercise 13–5 Cash (difference) .......................................................... Discount on notes payable ($10,000,000 x 6% x...