Document 1594647

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Chapter 13: Current Liabilities
and Contingencies
After studying this chapter you should be able to:
• Define current liabilities and describe how they are valued.
• Identify the nature and types of current liabilities.
• Explain the classification issues of short-term debt
expected to be refinanced.
• Identify types of employment related liabilities.
• Identify the criteria used to account for and disclose
contingencies.
• Explain the accounting for different types of contingent
liabilities.
• Indicate how current liabilities and contingencies are
presented and analyzed.
Definition of a Liability
• Definition of liability: A past event which gives rise to a
present unavoidable obligation to transfer assets in the
future. Notice how the definition is related to time.
– More than pure debts of a firm for which you will receive
a bill.
– Can possess quasi-ownership characteristics, e.g.,
convertible bonds payable.
• Division of liabilities into current (short term) and
noncurrent (long term) classifications.
– This distinction is related to the operating cycle of a
business.
3
Definition of a Liability
• Current liabilities are those liabilities that are paid off or
consume a current asset (CA) within one year or the
operating cycle, if longer.
– The concept of present value is not considered as the
time period is considered very short. They are carried
at maturity value.
– Beware of the understatement of current liabilities (CL):
» Working capital (or CA - CL) would be overstated if CL
are understated.
» Current ratio (or CA / CL) would be overstated as well.
» You should follow conservatism.
4
Types of Current Liabilities
• Accounts Payable (A/P) is a trade account.
– This represents what is owed to others for goods or
services.
– Short term, interest-free account (paid promptly).
– This account should be reviewed in a purchases cut-off
test to make sure the inventory is recorded in the proper
period as well as the related liability.
• Notes Payable (N/P)
– Trade notes issued for
inventory, supplies.
– Short-term notes may arise
from cash loans.
5
Types of Current Liabilities
– Interest-bearing notes payable
» N/P should be credited at face value.
» The interest paid on due dates, principal at maturity.
» The notes are subject to accruals as any other
account.
Example of an interest bearing N/P (fair rate):
Information: You issue a $6,000, 10%, 6 month note to
obtain a loan, on 1/1/x1:
Cash
6,000
N/P
6,000
6
Types of Current Liabilities
6/30 To repay:
N/P
6,000
Interest Expense
300
Cash
6,300
– Non-interest bearing note may be issued.
» This means there is no stated rate on the note. There is
interest (bank fee) charged, however.
» Note discounted (or sold to) bank.
» Bank fee is initially stated as a percentage.
7
Types of Current Liabilities
Example of a non-interest bearing discounted note:
Information: You issue a $5,000, zero-interest bearing, 6
month note to a bank. The bank's discount rate is 8%.
– The maturity value of the note is the face value or
$5,000.
– The bank’s fee is based on the maturity value x discount
rate x time. This will yield how much cash interest you
are charged.
– The note is discounted. This means the effect of the
interest is removed ahead of time.
– The cash you receive is the maturity value less the bank
fee.
8
Types of Current Liabilities
– Bank fee = $5,000 x .08 x 6/12 = $200
– Cash proceeds = $5,000- 200 = $4,800
Cash
4,800
Discount N/P
200
N/P
5,000
Payment:
N/P
5,000
Interest Expense
Cash
Discount N/P
200
5,000
200
9
Types of Current Liabilities
Note how the discounting (removal of interest at inception
of transaction) influences the rate paid. It raises the rate
from the bank discount rate to the actual or effective rate.
actual annual interest rate =
$400 =
8.4%
$4,800
The prior non-interest bearing example could be contrasted
to a present value calculation which reflects the removal of
interest over time.
Same example as before ($5,000 N/P, no stated interest rate,
6 month duration and a prevailing interest rate for notes of
this type of 8%.
10
Types of Current Liabilities
– PV = $5,000 ( .96154) = $4,808
where n = 1, i = 4% (semi)
Cash
4,808
Discount N/P
actual i (semi) = $192 = 4%
192
N/P
N/P
$4808
5,000
5,000
Interest expense
192
Cash
Discount N/P
5,000
192
11
Types of Current Liabilities
– What if the rate is unreasonable? Interest will be part
cash and part amortized discount.
Example: Suppose you have a $6,000, 3 year note bearing
3% interest payable annually, when the prevailing rate
of interest is 15%. Note was given in the purchase of
equipment. The difference in rates is considered
unreasonable.
PV = $6,000 ( .65752) =
$3945 n = 3 and i = 15%
plus
PV-AO = $180 ( 2.28323) = $411
n = 3 and i = 15%
$4356
$180 = .03 x $6,000 (cash interest annuity)
12
Types of Current Liabilities
To record issuance of note:
Equipment
4,356
Discount N/P
1,644
N/P
6,000
To amortize and record interest expense (at 15%):
(First period)
Interest expense
653
Cash
180
Discount N/P
473
13
Types of Current Liabilities
Other Current Liabilities
• Current maturities of long term debt.
– The amount due next fiscal year.
Capital
Stock
– It is not a current liability if:
» Paid from noncurrent assets.
» It is to be restructured (topic of Advanced
Accounting).
» It is to be converted to capital stock.
– Noncurrent portions will be considered current if they
are callable and debtor is in violation of the agreement
(other than grace period).
14
Types of Current Liabilities
– Current liabilities expected to be refinanced:
» Not a current liability if both the following criteria are
met:
• Intent to refinance is present.
• Ability to refinance is present as demonstrated by
an actual agreement (subsequent events).
– Noncancelable agreement.
15
– At the balance sheet date the
debtor not in violation of the
agreement.
– The lender is capable of
honoring the agreement.
– The amount excluded cannot
exceed amount of refinancing
(conservative estimate).
– Disclosure of obligations
expected to be refinanced
requires a description of the
agreement, the terms of
agreement, equity to be
issued, if any.
16
Types of Current Liabilities
• Dividends Payable
– Cash dividends give rise to a current liability.
– Arrearages on preferred stock are memo
entry only. Disclosed in a footnote.
– Stock dividends are a capitalization of
retained earnings.
» Transfer from retained earnings to the
stock accounts an appropriate amount.
» All accounts involved are owner equity
accounts. No liability arises from stock
dividends!
17
Types of Current Liabilities
• Returnable Deposits
– Usually contains both current and
noncurrent liability portions.
– Liability on advance sale tickets, tokens,
certificates, deferred revenues.
» These are liabilities until the service is
performed. Revenue or gain is recorded
when service performed or time period
lapses.
– Collections for third parties-- A ”wash”
transaction.
» Sales taxes
18
Types of Current Liabilities
Cash (A/R)
XX
Sales*
XX
Sales Tax Payable
XX
*If the credit to sales is inclusive of sales tax you must
separate the two. Sales = (Sales tax rate)(Sales ) +
Sales.
19
Payroll
• Payroll gives rise to a series of current liabilities.
– Withholdings
– Unemployment insurance, disability
– Employee authorized deductions
– Net payroll
– Social Security Taxes (FICA plus Medicare) (page
656)
» Employee and employer portions (matching).
» FICA 6.2% + Medicare 1.45% = 7.65% (will
vary over time).
» FICA first $65,400; Medicare no ceiling (will
vary over time).
20
Payroll
– Unemployment Insurance:
» FUI (Federal Unemployment Insurance) 6.2% first
$7,000.
» SUI (State Unemployment Insurance), first $7,000,
rate by individual company related to employment
history. There is a maximum offset to the federal
rate of 5.4%.
– Payroll entries:
21
Payroll
Gross Payroll
XX
FICA withholdings (employee) (payable)
XX
Federal & State withholdings (payable)
XX
Other withholdings, stock options, etc. (Pay) XX
Net Payroll Payable
Payroll Tax Expense
XX
XX
FICA payable (employer)
XX
FUI payable
XX
SUI payable
XX
Disability payable
XX
22
Types of Current Liabilities
– These entries are followed by those to pay the payroll
and remit taxes to the government.
– Bonus agreements are additional compensation which
may give rise to an additional liability. (See chapter
appendix.)
• Contingencies Following conservatism you are chiefly
concerned with losses! It will depend on the particular
scenario whether you journalize the potential loss, disclose
the loss or do nothing
– Has asset been impaired? Probable*, possible, remote
– Can the loss be estimated? Yes*, No
23
Types of Current Liabilities
– If both the conditions with a * are met then the
contingency should be journalized.
» If the contingency is probable and cannot be
estimated it should be disclosed but not journalized.
» If it is possible and can or cannot be estimated then it
should be disclosed but not journalized.
» If the contingency is remote then nothing is done.
– Litigations, claims and assessments.
» Accrual is rarely done.
» Unasserted claims. If it is probable there is a claim,
the outcome is fairly certain and can be estimated it
should be accrued but is rarely done. Why not?
24
Types of Current Liabilities
• Guarantee and Warranty Costs.
– Cash (Tax) Method
» Pay as you go. Violates matching.
– Accrual Methods:
» Expense Warranty (best GAAP)--operating expense
the period service performed
» Sales Warranty. This defers some profit until the
time when costs are incurred or the warranty expires
» Please see pages 664-665.
– Different methods can be used on the return and on the
books.
25
Types of Current Liabilities
• Compensated absences (FASB #43) You should accrue if
the:
» Service has been rendered, payment is probable
and can be reasonably estimated.
» Vested or accumulated.
• Vested--legal right to receive even if employee
terminated.
• Accumulated--legal right to receive unless
employee terminated.
» Sick pay is normally accrued if vested; vacation pay
is normally accrued if it accumulates.
25
26
Types of Current Liabilities
– A change in wage rate between time the accrual done
and vacation/sick taken is treated as a change in
accounting estimate.
27
Types of Current Liabilities
• Pensions and Postretirement Health Care Benefits
– Definition of liability had to be broadened to
accommodate the changes in accounting for these
areas.
– Topic of Chapter 21. Complex topic, use of
spreadsheets.
– Pension expense has five basic sources (accounting for
postretirement health care benefits is similar)
1. Current service component
2. Interest on the obligation
3. Asset return offset
28
Types of Current Liabilities
4. Amortization of prior service cost
(“smoothing”)
5. Amortization of actuarial and asset
gains and losses (again
“smoothing” through use of the
corridor and averaged assets).
– Expense is not always equal to the cash
funding of plan.
– Concept of off-B/S assets and liabilities.
– Pension expense is tax deductible,
health care is not.
29
Types of Current Liabilities
• Property taxes
– When should these payments be recorded?
– Against which accounting period should they be
charged?
– Review pages 653-655.
• Conditional Payments
– These are estimated tax payments.
– Amounts must be estimated as exact amounts are not
known when partial payments made.
30
Types of Current Liabilities
– Tax liabilities appear on the financial statements of
corporations; responsibility of individuals in sole
proprietorships and partnerships.
– If no differences exist in GAAP used on the return and
financial statements then the final tax accrual is done.
» Estimated payments made periodically--debit
expense and credit cash.
» To do the final entry first reverse tax expense off
books--debit tax payable and credit tax expense.
(You must do this so tax expense can be calculated
on income before tax.) Then do accrual:
31
Types of Current Liabilities
» Debit tax expense and credit tax payable. Payables
will net to the proper amount and expense will be
correct.
– More complex if principles on return and F/S are
different. We will see Deferred Taxes in Chapter 20.
• Premiums and Coupons The FASB did not specifically
address these.
– Follow matching. Toys in candy boxes, redemptions of
UPC markers plus cash for a novelty item, etc. To buy:
Premium inventory
Cash
XX
XX
32
Types of Current Liabilities
To sell good or service:
Cash
XX
Sales
XX
Cash
XX
Premium Expense
XX
Premium inventory
XX
To record actual redemptions
Premium Expense
XX
Provision for Premium (liability) XX
To match remainder
33
Types of Current Liabilities
Subsequent periods to honor offer:
Provision for Premium
XX
Cash
XX
Premium Inventory
XX
•Uninsured losses also known as self-insurance.
– Actual losses only may be deducted; accrue current
obligations.
– In reality no insurance since risk of loss has not been
assumed by independent third party.
•Environmental liability. Please page 667.
– Generally disclosed but not accrued.
– If probable and you can estimate, accrue.
34
Intermediate Accounting, Ninth Edition
Kieso and Weygandt
Prepared by
Catherine Katagiri, CPA
The College of Saint Rose
Albany, New York
John Wiley & Sons, Inc.
1
Chapter 14: Long-Term Liabilities
After studying this chapter you should be able to:
• Describe the formal procedures associated with issuing
long-term debt.
• Identify various types of bond issues.
• Describe the accounting valuation for bonds at date of
issuance.
• Apply the methods of bond discount and premium
amortization.
• Describe the accounting procedures for the extinguishment
of debt.
• Explain the accounting procedures for long-term notes
payable.
• Explain the reporting of off-balance sheet financing
arrangements.
Nature of a Long-Term Liabilities
• Long-term liabilities:
– Probable future sacrifices of economic benefits arising
from present obligations that are not payable within a
year or the operating cycle of a business, whichever is
longer.
– More or less permanent in some form (like stock
financing).
– Discrete maturity date.
3
Nature of a Long-Term Liabilities
– Does not carry the right
to select/participate in
management.
– Tax deductible; interest
a legal obligation.
– Positive leverage
possible.
– Covenants and
restrictions must be
disclosed.
4
Bonds Payable Definitions
• Bonds Payable is an agreement (indenture) to pay a series
of cash interest payments and a final payment of principle.
– Stated amount (principle or par).
– Maturity date.
– Periodic interest (stated rate determines cash interest).
– Types of Bonds Payable:
» Secured--backed by some form of collateral.
» Unsecured--not backed by some form of collateral.
» Term versus serial--term bonds all have a single
maturity date, serial bonds have staggered maturity
dates.
5
Bonds Payable Definitions
» Convertible (holder)--convertible into another of the
firm’s securities. Commodity-backed--redeemable in
a measure of a commodity (wheat, oil, etc.)
» Deep discount--discounted at a high interest rate
with interest paid at maturity (zero coupon bonds).
» Registered--each time the bond is sold the security
must be surrendered and a new one issued.
» Bearer (coupon)--transfer of ownership
accomplished by delivery of certificate.
Bond
Payable
65
Bonds Payable Definitions
» Income bonds payable--no interest paid unless the
firm is profitable.
» Revenue bonds payable--interest is paid from
specific sources.
» Callable bonds payable --gives the issuer the right
to retrieve (call) the bonds prior to maturity.
– Quality ratings--Moody’s, Standard & Poor’s
7
Valuation of Bonds Payable
• Price set between buyer (holder) and seller (issuer)
– An interest-bearing bond normally involves an annuity
(for the cash interest payments) and a single lump-sum
payment (for the principal).
– Concept of present value (time value of money) is
important here! You need to know the “facts” of the
situation:
» Par (principal or face value) of bond payable.
» Stated interest rate (SR)--determines cash interest.
» Maturity date and interest periods.
» Prevailing interest or rate of return required by the
average investor (the market) for investments of this
type.
8
Valuation of Bonds Payable
Example of a B/P which will sell at the par, i.e., when the stated
rate is equal to the market rate.
– Information: On 1/1/x1 offered and sold $80,000, 5 year,
semi-annual bonds with a stated rate of interest of 10%
and a market (yield) rate of 10%. There is a meeting of the
minds.
Cash interest = $80,000 x .10 x 6/12 = $4,000
PV-AO = $4,000 (7.722) = $ 30,888
plus
PV
where n = 10 and i = 5% (MR)
= $80,000 (.614) =
$ 49,120
$ 80,000 (rounded)
9
Valuation of Bonds Payable
Cash
80,000
B/P
No discount or
80,000
premium arises
Sale of B/P at a discount (below par)
– Information: Same bond as before but sold to yield a market
rate of 12%, semiannual; offered and sold on 1/1/x1.
PV-AO = $4,000 (7.360) = $29,440 where n= 10, i = 6%
plus
PV
= $80,000 (.558)
= $44,640
$74,080
10
Valuation of Bonds Payable
Journal entry:
Cash
74,080
Discount on B/P
5,920
B/P
80,000
Balance sheet presentation:
B/P
less
Disc B/P
B/P, net
$80,000
5,920
$74,080 (book or carrying value)
Note: Short term bonds--discount or premium is not separately
reported. Not enough time to amortize it.
11
Valuation of Bonds Payable
Sale of bonds at a premium (above par).
– Arises when the SR (cash interest you promise) is greater
than what the market demands. Price of your bond is bid
up until the cash interest divided by the amount given up
for the bond equals the market rate of interest.
– Do some calculations yourselves following our example
but set the MR at 6% and keep the SR at 10%
12
Recording Bond Interest Expense
– To record the issuance of a B/P at a premium: (create
an adjunct rather than a contra account)
Cash
XX
B/P, par
XX
Premium B/P
XX
•Long-term bonds--discount or premium must be amortized to
properly reflect interest expense.
–Effective interest method is GAAP. Yields a constant rate of
interest on a fluctuating level of debt. You must report interest at
the actual market or the effective yield you are paying, not some
arbitrary stated rate.
13
Recording Bond Interest Expense
– Straight-line method of amortizing the discount or premium.
» Not GAAP if it yields results which are materially
different from the effective interest method.
» Yields a constant dollar amount of interest even
though the debt level is changing. The implication
is the rate is varying over the life of the debt (when
in fact it is constant).
– Interest expense = cash interest + discount amortization
when the SR < MR.
– Interest expense = cash interest - premium amortization
when the SR > MR.
14
Recording Bond Interest Expense
Our example when bond sold at a discount:
Straight-line amortization:
$5,920 = $592
(divided by number of periods available)
10
Entry: (every six months)
Interest Expense
Discount B/P
Cash
4,592
592
4,000
15
Recording Bond Interest Expense
Effective Interest Method to amortize discount: 1st period
– Cash interest = stated rate x par; $80,000 x .05 = $4,000
– Interest expense = carrying value of debt x market rate
= $74.080 x .06 = $4,445
Entry: (first payment)
Interest Expense
Cash
Discount B/P
4,445
4,000
445
15
16
Recording Bond Interest Expense
2nd period: (Note: CV of debt has increased toward par)
Cash interest = $4,000
Interest expense = ($74,080+445)(.06) = $4,472 or
= $74,525 (.06) = $4,472
Interest Expense
Cash
Discount B/P
4,472
4,000
472
17
Recording Bond Interest Expense
– Please see amortization tables on page 708-709--read!
Note the characteristics of the table and its usefulness
in drawing up the required journal entries.
– Note in our example (discount situation):
Cash interest = $4,000 = .05 (stated rate)
$80,000
but:
$4,472
=
.06 (market rate or effective yield)
$74,080
18
Bonds Issued Between Interest Dates
• Bonds issued between interest dates:
– Interest “runs” with the bond.
– Bonds are subject to accruals.
Example: Suppose in our prior example the $80,000 B/P (
SR = 10%, MR = 12%, semiannual) is offered for sale on
1/1 and sold on 4/1. Interest dates are 6/30 & 12/31.
– To issue (as before) present value of the cash flows =
$74,080
– Buyers also prepay three months worth of interest.
$80,000 x .10 x 3/12 = $2,000
19
Bonds Issued Between Interest Dates
Entry:
4/1
Cash
76,080
Disc B/P
5,920
Bonds Payable
Interest Exp (or Pay)
80,000
2,000
–Interest payment is paid on 6/30 (3 months later):
20
Bonds Issued Between Interest Dates
Interest Expense
4,222
Cash
4,000
Disc B/P
222
Discount amortized:
Effective interest method
$74,080 x .06 x 3/6 = $2,222 (interest exp) - $2,000 = $222
or straight-line:
$5,920
x
3 months
=
$312
57 months
21
Bonds Payable Concerns
• Costs of Issuing Bonds
– Deferred charges (not an offset to the proceeds).
– Amortize over the life of the bonds.
– Not expensed (APB # 21).
• Treasury Bonds
– Repurchase of your own bonds with intent to resell.
– Contra bonds payable account.
– Shown on the balance sheet at par value as a deduction
from the bonds payable issued to disclose a net figure
of bonds payable outstanding.
22
Bonds Payable Concerns
• Extinguishment of Debt
– At maturity (no premium or discount remaining).
Bonds payable
XX
Cash, etc.
XX
– Early Payment FASB # 4--Gain or Loss Extraordinary:
Bonds payable, par
XX
Premium (if any)
XX
Loss (if any)
XX
Discount (if any)
XX
Gain (if any)
XX
Cash, etc.
XX
23
Bonds Payable Concerns
• In-substance defeasance--FASB #16 “as if”
– A set aside of assets for future use in repayment of the
debt. The company still has the primary obligation to
repay the debt.
– Question: Can the company remove the debt and the
assets from the balance sheet even though the debt has
not been formally paid off?
– Previous to 1996 the answer was “yes--it is called an insubstance defeasance”.
– Please read page 711, footnote. FASB #125 no longer
recognizes an in-substance defeasance. Liability must
actually be retired prior to its removal from the balance
sheet.
24
Long-Term Notes Payable
• Long Term Notes Payable
– In substance same as bonds.
– Valuation: Present value of the future cash flows;
market rate not as obvious!
Example: Notes for cash: N/P $100,000 for $80,000 cash
Cash
80,000
Discount B/P
20,000
N/P
100,000
(impute i so PVCF = cash)
25
Notes Payable
Note for cash and other rights.
Example: You give a $10,000 non-interesting bearing
note payable for $10,000 cash and your promise to offer
discounts on future sales to the lender. Assume the
present value of the cash flows is $8,000.
Entry:
Cash
10,000
Discount N/P
2,000
Note Payable, face
10,000
Deferred Revenues
2,000
26
Notes Payable
– Notes in non-cash transactions (building for note
payable)
– Interest rate that is stated is presumed to be fair
unless obviously unreasonable or wholly unrelated
to the cash price.
• Mortgage notes payable Long term secured note
– Face value is equal to the present value of the future
cash flows (no points).
– Points = % of face value. They represent extra interest.
– Divide between current and noncurrent portions.
27
Notes Payable
• Mortgage Notes Payable:
– Fixed and variable rates of interest.
– SAM--shared appreciation mortgage.
– Negative equity possible.
• Short term obligations to be refinanced--Chapter 13
– Classified as current liabilities if
» there is an ability to refinance.
» management intents to refinance.
28
Off-Balance Sheet Financing
• Financial Engineering--Please see page 719.
– Debt swaps.
– Off balance sheet financing may enhance a firm’s
financial position because it reduces the presence of
restrictive covenants, betters ratios, and enhances
liquidity measures. For example,
» R & D arrangements
» Leases
– Derivative financial instruments--value derived from the
underlying asset or security.
29
Analysis of Long-Term Debt
• Long-term creditors and stockholders are interested in a
firm’s long-term solvency. A financial ratio to help assess
this solvency would be:
Debt to total Assets =
Total debt = %
Total Assets
The greater the percentage the greater the risk to the creditors.
This must be compared to similar firms in the same industry to be
judged acceptable or not.
30
Analysis of Long-Term Debt
• Times interest earned is equal to:
Times Interest Earned =
Income before income taxes and interest expense
Interest expense
– Times interest earned indicates the ability to pay interest on
time.
» It provides a measure of security to the debtholders.
» Must be compared to similar firms by creditors and
investors to determine if it is adequate.
31
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