Chapter 13

Name 2 loss contingencies that almost always are accrued.

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.

What are the essential characteristics of liabilities for purposes of financial reporting?

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 assets or provide services) to other entities. 3. that result from past transactions or events.

Under what circumstances should a loss contingency by accrued?

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.

Define a loss contingency. Provide 3 examples.

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.

Under what conditions should an employer accrue an expense and the related liability for employees' compensation for future absences? How do company custom and practice affect the accrual decision?

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 for unused sick days or are allowed to be paid for a certain number of days taken as sick days, even when their absence is not due to illness, a liability for unused sick pay should be recorded.

How does commercial paper differ from a bank loan? Why is the interest rate often less than for commercial paper?

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.

How do U.S. GAAP and IFRS differ in their use of present values when measuring contingent liabilities?

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.

How do U.S. GAAP and IFRS differ in their treatment of a range of equally likely losses?

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.

Amounts collected for third parties represent liabilities until remitted. Provide several examples of this kind of collection.

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.

How do companies account for gift cards?

Gift cards are a particular form of advance collection of revenues. When the payment is received, the seller debits cash and credits a deferred revenue liability. Later, deferred 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.

Suppose the analysis of a loss contingency indicates that an obligation is not probable. What accounting treatment, if any, is warranted?

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.

Bronson Distributors owes a supplier $100,000 on open account. The amount is payable in 3 months. What is the theoretically correct way to measure the reportable amount for this liability? In practice, how will it likely be reported? Why?

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.

What distinguishes current liabilities from long-term liabilities?

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.

Bank loans often are arranged under existing lines of credit. What is a line of credit? How does a non-committed line of credit differ from a committed line?

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.

At December 31, the end of the reporting period, the analysis of a loss contingency indicates that an obligation is only reasonably possible, though its dollar amount is readily estimable. During February, before the financial statements are issued, new information indicates the loss is probable. What accounting treatment is warranted?

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.

Long-term obligations usually are reclassified and reported as current liabilities when they become payable within the upcoming year. So, a 25-year bond issue is reported as a long-term liability for 24 years but normally is reported as a current liability on the balance sheet prepared during the 25th year of its term to maturity. Name a situation in which this would not be the case.

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.

Distinguish between the accounting treatment of a manufacturer's warranty and an extended warranty. Why the difference?

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 and is identified as a separate performance obligation. As such, it constitutes a separate sales transaction and is recorded as such.

List and briefly describe the 3 categories of likelihood that a future event(s) will confirm the incurrence of the liability for a loss contingency.

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.

When companies have debt that is not due to be paid for several years but that is callable (due on-demand) by the creditor, do they classify the debt as current or as long-term?

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.

Salaries of $5,000 have been earned by employees by the end of the period but will not be paid to employees until the following period. How should the expense and related liability by recorded? Why?

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, and recognizes that a liability has been created by the employee earning wages for which she has not yet been paid.

How do IFRS and U.S. GAAP differ with respect to the classification of debt that is expected to be refinanced?

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).

What is the difference between the use of the term contingent liability in U.S. GAAP and IFRS?

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.

How are refundable deposits and customer advances similar? How do they differ?

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.

After the end of the reporting period, a contingency comes into existence. Under what circumstances, if any, should the contingency be reported in the financial statements for the period ended?

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).

Suppose the EPA is in the process of investigating Ozone Ruination Limited for possible environmental damage but has not proposed a penalty as of 12/31/17., the company's fiscal year-end. Describe the 2-step process involved in deciding how this unasserted assessment should be reported.

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.

Banks sometimes loan cash under noninterest-bearing notes. Is it true that banks lend money without interest?

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.

Assuming you report under IFRS: You are the plaintiff in a lawsuit. Your legal counsel advises that your eventual victory is inevitable. "You will be awarded $12 million." your attorney confidently asserts. Describe the appropriate accounting treatment.

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.

You are the plaintiff in a lawsuit. Your legal counsel advises that your eventual victory is inevitable. "You will be awarded $12 million." your attorney confidently asserts. Describe the appropriate accounting treatment.

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."