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Chapter Thirteen Current Liabilities and Contingencies. Chapter 13. Current Liabilities and Contingencies. CHARACTERISTICS OF LIABILITIES. Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements.
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Chapter Thirteen Current Liabilities and Contingencies
Chapter 13 Current Liabilities and Contingencies
CHARACTERISTICS OF LIABILITIES • Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements. • Some liabilities are not contractual obligations and may not be payable in cash. • A liability has 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
What is a Current Liability? LIABILITIES Current Liabilities Long-term Liabilities Generally, payable within one year. Formally, expected to be satisfied with current assets (or by the creation of other current liabilities). Conceptually, should be recorded at present value, but ordinarily are reported at maturity amounts.
GENERAL MILLS, INC. BALANCE SHEET MAY 27, 2004 AND MAY 28, 2003 ($ in millions) ASSETS [BY CLASSIFICATION] LIABILITIES Current Liabilities: 2004 2003 Accounts payable $1,145 $1,303 Current portion of long-term debt 233 105 Notes payable 583 1,236 Other current liabilities 796 800 Total current liabilities $2,757 $3,444 Long-term Liabilities: [LISTED INDIVIDUALLY] Shareholders’ equity [BY SOURCE]
8: Notes Payable The components of notes payable and their respective weighted average interest rates at the end of the period are as follows: 20042003 Weighted Weighted Dollars in millions: Average Average Note Interest Note Interest Payable Rate Payable Rate U.S. commercial paper $441 1.2% $1,415 1.4% Canadian commercial paper 159 2.1 28 3.3 Euro commercial paper 499 2.1 527 1.5 Financial institutions 234 6.7 366 1.4 Amount reclassified to long-term debt (750) – (1,100) – Total notes payable $583 $1,236
8: Notes Payable (cont.) To ensure availability of funds, we maintain bank credit lines sufficient to cover our outstanding short-term borrowings. As of May 30, 2004, we had $1.85 billion fee-paid lines and $264 million uncommitted, no-fee lines available in the U.S. and Canada. In the third quarter of fiscal 2004, we entered into an agreement for a new $750 million credit facility, expiring in January 2009. That facility replaced a $1.1 billion, 364-day facility, which expired January 22, 2004. The new credit facility, along with our existing $1.1 billion multi-year facility that expires January 2006, brings our total committed back-up credit amount to $1.85 billion. These revolving credit agreements provide us with the ability to refinance short-term borrowings on a long-term basis; accordingly, a portion of our notes payable has been reclassified to long-term debt.
Interest Interest on notes is calculated as : Amount borrowed Interest rate is always stated as an annual rate. Interest owed is adjusted for the portion of the year that the debt is outstanding.
Note Issued for Cash On May 1, Affiliated Technologies, Inc., a consumer electronics firm, borrowed $700,000 cash from First BancCorp under a noncommitted short-term line of credit arrangement and issued a 6-month, 12% promissory note. Interest was payable at maturity. May 1 Cash 700,000 Notes payable 700,000 November 1 Interest expense ($700,000 x 12% x 6/12)42,000 Notes payable 700,000 Cash ($700,000 + 42,000) 742,000
Example On September 1, Tru Fashions borrows $80,000 from Second Bank. The note is due in 6 months and has a stated interest rate of 9%. Cash 80,000 Notes payable 80,000 How much interest does Tru owe at year-end, on Dec. 31? a. $ 2,400 b. $ 3,600 c. $ 7,200 d. $87,200
Interest is calculated as: Face Annual Time to Amount Rate maturity $80,000 9% 4/12 $2,400 interest. × × = × × = Example On September 1, Tru Fashions borrows $80,000 from Second Bank. The note is due in 6 months and has a stated interest rate of 9%. How much interest does Tru owe at year-end, on Dec. 31? a. $ 2,400 b. $ 3,600 c. $ 7,200 d. $87,200
Noninterest-Bearing Note The proceeds of the note are reduced by the interest in a “noninterest-bearing” note. Situation: $700,000 noninterest-bearing note, with a 12% “discount rate.” The $42,000 interest is “discounted” at the outset, rather than explicitly stated: May 1 Cash (difference) 658,000 Discount on notes ($700,000 x 12% x 6/12) 42,000 Notes payable (face amount) 700,000 November 1 Interest expense 42,000Discount on notes 42,000 Notes payable (face amount) 700,000Cash 700,000
Noninterest-Bearing Note The amount borrowed is only $658,000, but the interest is calculated as the discount rate times the $700,000 face amount. This causes the effective interest rate to be higher than the 12% stated rate: $ 42,000 interest for 6 months ÷ $658,000 amount borrowed = 6.38% rate for 6 months x 12/6 to annualize the rate __________ = 12.76% effective interest rate
ACCRUED LIABILITIES Liabilitiesaccrue forexpenses that are incurred, but not yet paid. Recorded by adjusting entries at the end of the reporting period, prior to preparing financial statements. Common examples are: salaries and wages payable, income taxes payable, and interest payable.
ACCRUED INTEREST PAYABLE Assume the fiscal period for Affiliated Technologies ends on June 30, two months after the 6-month note is issued. The issuance of the note, intervening adjusting entry, and note payment would be recorded as shown below: Issuance of note May 1 Cash 700,000Note payable 700,000 Accrual of interest on June 30 Interest expense ($700,000 x 12% x 2/12) 14,000Interest payable 14,000 Note payment November 1 Interest expense ($700,000 x 12% x 4/12) 28,000 Interest payable (from adjusting entry) 14,000 Note payable 700,000Cash ($700,000 + 42,000) 742,000
Liabilities from Advance Collections • Refundable Deposits • Advances from Customers • Collections for Third Parties
Customer Advance Tomorrow Publications collects magazine subscriptions from customers at the time subscriptions are sold. Subscription revenue is recognized over the term of the subscription. Tomorrow collected $20 million in subscription sales during its first year of operations. At December 31, the average subscription was one-fourth expired. ($ in millions) When Advance is Collected Cash 20 Unearned subscriptions revenue 20 When Product is Delivered Unearned subscriptions revenue 5 Subscriptions revenue 5
Short-term obligations can be reported as noncurrent liabilities only if the company: (a) intends to refinance on a long-term basis and (b) demonstrates theability to do so: Short-Term Obligations Expected to Be Refinanced by either an existing refinancing agreement byactual financing (prior to the issuance of the financial statements) or The specific form of the long-term refinancing (bonds, bank loans, equity securities) is irrelevant. The concept of substance over form.
A loss contingencyis an existing uncertain situation involving potential loss depending on whether some future event occurs. Contingencies
Two factors affect whether a loss contingency must be accrued and reported as a liability: the likelihood that the confirming event will occur. whether the loss amount can be reasonably estimated. Contingencies
Contingencies – Likelihood of Occurrence • Probable • A confirming event is likely to occur. • Reasonably Possible • The chance the confirming event will occur is > remote, but < likely. • Remote • The chance the confirming event will occur is slight.
Product Warranties and Guarantees • The contingent liability for product warranties almost always is accrued. Caldor Health introduced a new therapeutic chair carrying a 2-year warranty against defects. Estimates indicate warranty costs of 3% of sales during the first 12 months following the sale and 4% the next 12 months. During December of 2006, its first month of availability, Caldor sold $2 million of the chairs. • During December • Cash (and accounts receivable) 2,000,000 Sales revenue 2,000,000 • December 31, 2006 (adjusting entry) • Warranty expense ([3% + 4%] x $2,000,000) 140,000 Estimated warranty liability 140,000
If information becomes available that sheds light on a contingency that existed when the fiscal year ended, that information should be used in determining the probability of a loss contingency materializing and in estimating the amount of the loss. Cause of Loss Contingency Clarification Fiscal Year Ends Financial Statements Subsequent Events
UNASSERTED CLAIMS AND ASSESSMENTS 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. Example: The IRS is in the process of auditing a company’s tax returns, but has not proposed a deficiency assessment. Since the claim or assessment is unasserted as yet, a two-step process is involved in deciding how it should be reported: 1. Is a claim or assessment probable? {If not, no disclosure is needed.} 2. Only if a claim or assessment is probable should we evaluate (a) thelikelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated. If the conclusion of step 1 is that the claim or assessment is not probable, no further action is required.
Gain Contingencies Desirable to anticipate losses, but recognizing gains should await their realization. As a general rule, we never record GAIN contingencies. Should be disclosed in notes to the financial statements. Care should be taken that the disclosure note not give "misleading implications as to the likelihood of realization."
