Chapter 13 Current Liabilities and Contingencies Copyright 2018

Chapter 13 Current Liabilities and Contingencies Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -1 Characteristics of Liabilities Future sacrifices of economic benefits Characteristics Arise from present obligations Result from past transactions or events Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -1 Current Liabilities Obligation payable within one year or firm’s operating cycle Characteristics Satisfied from current assets Satisfied by creation of other current liabilities Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -1 Recording Current Liabilities • Liabilities should be recorded at their present values – Except liabilities payable within one year which are ordinarily recorded at maturity amounts Most common examples: • Accounts payable • Notes payable • Commercial paper • • • Income tax liability Dividends payable Accrued liabilities Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -1 Accounts Payable and Trade Notes Payable • Obligations to suppliers of merchandise or of services • Key accounting considerations are: – Determining existence – Recording in the appropriate accounting period Accounts Payable • • Payable on open account Credit instrument: invoice Short duration Noninterest-bearing and reported at face amounts Trade Notes Payable • Credit instrument: written promissory note • Longer duration • Bear interest Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -1 Current Liabilities—General Mills GENERAL MILLS, INC Excerpt from Consolidated Balance Sheets ($ in millions) May 31, 2015 and May 27, 2014 Liabilities Current Liabilities 2015 2014 Accounts payable $1, 684. 0 $1, 611. 3 1, 000. 4 1, 250. 6 615. 8 111. 7 1, 589. 9 1, 449. 9 $4, 890. 1 $4, 423. 5 Current portion of long-term debt Notes payable Other current liabilities Total current liabilities Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -1 Current Liabilities—General Mills (continued) Note 8. Debt Notes Payable The components of notes payable and their respective weighted-average interest rates at the end of the periods were as follows: 2015 Dollars in Millions: U. S. commercial paper Financial institutions Total notes payable Note Payable 2014 Weighted Average Interest Rate Note Payable Weighted Average Interest Rate $432. 0 0. 3% $1, 007. 6 0. 2% 183. 8 9. 5 104. 1 12. 1 $615. 8 3. 0% $1, 111. 7 1. 3% Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -1 Concept Check: Current Liabilities Which of the following statements is true about current liabilities? a. Current liabilities are obligations payable within one year or within the firm’s operating cycle, whichever is longer b. Current liabilities are ordinarily recorded at maturity amounts rather than present value c. Current liabilities as those expected to be satisfied with current assets or by the creation of other current liabilities d. All of the above The correct answer is d. All of the above statements are true concerning current liabilities. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Short-Term Notes Payable Characteristics • Temporary financing from bank • Promissory note is signed • Lower interest rates than longterm debt • Companies have flexibility while selecting financial alternatives Commercial paper Unsecured loans Credit lines Secured loans Financing alternatives Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Credit Lines • A line of credit is an agreement to provide short-term financing, with amounts withdrawn by the borrower only when needed Credit Lines Committed Formal agreement Commitment fee to bank to keep a credit line amount available to the company Noncommitted Informal agreement Borrow up to a prearranged limit without formal loan procedures Borrower may be required to maintain a compensating balance in the bank Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Disclosure of Credit Lines—IBM Corporation Note J. Borrowings (in part) LINES OF CREDIT: In 2015, the company extended the term of its five-year, $10 billion Credit Agreement (the “Credit Agreement”) by one year to November 10, 2020. The total expense recorded by the company related to this global credit facility was $5. 3 million in 2015, $5. 4 million in 2014, and $5. 4 million in 2013. The Credit Agreement permits the company and its Subsidiary Borrowers to borrow up to $10 billion on a revolving basis. Borrowings of the Subsidiary Borrowers will be unconditionally backed by the company. . As of December 31, 2015, there were no borrowings by the company, or its subsidiaries, under the Credit Agreement. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Interest • Paid by borrowing company during the loan term • Return for using lender’s money • Stated in terms of a percentage rate to be applied to the face amount of the loan Face amount × Annual rate × Time to maturity Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Note Issued for Cash On May 1, Affiliated Technologies, Inc. , a consumer electronics firm, borrowed $700, 000 cash from First Banc. Corp under a noncommitted short-term line of credit arrangement and issued a six-month, 12% promissory note. Interest was payable at maturity. Journal Entry May 1 Cash Notes payable November 1 Interest expense Notes payable Cash Debit Credit 700, 000 $700, 000 × 12% × 6/12 42, 000 700, 000 742, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Noninterest-Bearing Note On May 1, Affiliated Technologies, Inc. , a consumer electronics firm, borrowed $700, 000 cash from First Banc. Corp under a sixmonth noninterest-bearing note, with a 12% discount rate. Journal Entry Debit May 1 $700, 000 × 12% × 6/12 Cash Discount on notes payable Notes payable 658, 000 42, 000 November 1 Interest expense Discount on notes payable Notes payable Cash 42, 000 Credit 700, 000 42, 000 700, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Noninterest-Bearing Note (continued) The amount borrowed under this arrangement 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 To annualize: 6. 38% × 12/6 = 12. 76% effective interest rate When interest is discounted from the face amount of a note, the effective interest rate is higher than the stated discount rate. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Secured Loans • Loan made by pledging a specified asset of the borrower as collateral or security Pledging accounts receivable: When accounts receivable serves as a collateral Factoring receivables: When the receivables actually are sold outright to a finance company Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Commercial Paper • Refers to unsecured notes sold in minimum denominations of $25, 000 with maturities ranging from 30 to 270 days – Beyond 270 days the firm would be required to file a registration statement with the SEC • Interest often is discounted at issuance • Usually commercial paper is issued directly to the buyer (lender) and is backed by a line of credit with a bank – This allows the interest rate to be lower than in a bank loan Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -2 Concept Check: Interest Jamal borrowed $100, 000 on July 1, 2018, and signed a fouryear note bearing interest at 8%. Interest is payable in full at maturity on June 30, 2020. Jamal should report interest expense at December 31, 2018, of: a. b. c. d. $0 $4, 000 $8, 000 $32, 000 The correct answer is b: $100, 000 × 8% × 6/12 = $4, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Accrued Liabilities • Represent expenses already incurred but not yet paid (accrued expenses) • Recorded by adjusting entries • Usually combined and reported under a single caption in the balance sheet Common examples: – Salaries and wages payable – Income taxes payable – Interest payable Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Note with Accrued Interest LO 13 -3 On May 1, Affiliated Technologies, Inc. , borrowed $700, 000 cash from First Banc. Corp under a noncommitted short-term line of credit arrangement and issued a six-month, 12% promissory note. Interest was payable at maturity. Assume the fiscal period for Affiliated Technologies ends on June 30, two months after the six-month note is issued. Journal Entry Issuance of note on May 1 Cash Notes payable Debit Credit 700, 000 Accrual of interest on June 30 Interest expense ($700, 000 × 12% × 2/12) Interest payable 14, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Note with Accrued Interest (continued) LO 13 -3 On May 1, Affiliated Technologies, Inc. , borrowed $700, 000 cash from First Banc. Corp under a noncommitted short-term line of credit arrangement and issued a six-month, 12% promissory note. Interest was payable at maturity. Assume the fiscal period for Affiliated Technologies ends on June 30, two months after the six-month note is issued. Journal Entry Debit Credit Note payment on November 1 Interest expense ($700, 000 × 12% × 4/12) 28, 000 14, 000 Interest payable Notes payable 700, 000 Cash 742, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Salaries, Commissions, and Bonuses • Accrued liabilities arise in connection with compensation expense when employees have provided services but have not yet been paid as of a financial statement date VACATIONS, SICK DAYS, AND OTHER PAID FUTURE ABSENCES Four conditions for accrual of paid future absences: 1. The obligation is attributable to employees’ services already performed 2. The paid absence can be taken in a later year—the benefit vests or the benefit can be accumulated over time 3. Payment is probable 4. The amount can be reasonably estimated Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Paid Future Absences LO 13 -3 Davidson-Getty Chemicals has 8, 000 employees. Each employee earns two weeks of paid vacation per year. Vacation time not taken in the year earned can be carried over to subsequent years. During 2018, 2, 500 employees took both weeks’ vacation, but at the end of the year, 5, 500 employees had vacation time carryovers as follows: Employees 2, 500 2, 000 3, 500 8, 000 Vacation weeks earned but not taken 0 1 2 Total carryover weeks 0 2, 000 7, 000 9, 000 During 2018, compensation averaged $600 a week per employee. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Paid Future Absences (continued) Journal Entry When vacations were taken in 2018 Salaries and wages expense Cash (or wages payable) Debit 4, 200, 000 LO 13 -3 Credit 4, 200, 000 (2, 500 × 2 weeks × $600) + (2, 000 × 1 week × $600) December 31, 2018 (adjusting entry) Salaries and wages expense 5, 400, 000 Liability—compensated future absences 5, 400, 000 9, 000 carryover weeks × $600 When year 2018 vacations are taken in 2019 5, 400, 000 Liability—compensated future absences 300, 000 Salaries and wages expense 5, 700, 000 Cash Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Annual Bonuses Features • Tied to performance objectives to provide incentive to executives • Are compensation expense of the period in which they are earned Most common performance measures: Financial • Earnings per share • Net income • Operating income Nonfinancial • Customer satisfaction • Product or service quality Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Liabilities from Advance Collections LO 13 -2 Liabilities are created when deposits and advances are received from customers Advance collections Deposits and advances from customers Gift cards Collections for third parties Refundable deposits Advances from customers Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Refundable Deposits Rancor Chemical Company sells combustible chemicals in expensive, reusable containers. Deposits collected on containers delivered during the year were $300, 000. Deposits are forfeited if containers are not returned within one year. Ninety percent of the containers were returned within the allotted time. Deposits charged are twice the actual cost of containers. The inventory of containers remains on the company’s books until deposits are forfeited. Journal Entry When deposits are collected Cash Liability—refundable deposits Debit 300, 000 Credit 300, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Refundable Deposits (continued) 90% × $300, 000 Journal Entry Debit When containers are returned Liability—refundable deposits Cash 270, 000 When deposits are forfeited Liability—refundable deposits Revenue—sale of containers 30, 000 When deposits are forfeited Cost of goods sold Inventory of containers 15, 000 $300, 000 − $270, 000 Credit 270, 000 30, 000 15, 000 $30, 000 / 2 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Advances from Customers LO 13 -2 • Represent liabilities until the product or service is provided or the advance collected Examples • Gift certificates • Magazine subscriptions • Layaway deposits • Special order deposits • Airline tickets Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 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 $20 million in subscription sales during its first year of operations. At December 31, the average subscription was one-fourth expired. Journal Entry When advance is collected Cash Deferred subscription revenue When product is delivered Deferred subscription revenue Subscription revenue ($ in millions) Debit Credit 20 20 5 5 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Gift Cards (Gift Certificates) Cash received on sale recorded as deferred revenue Later recognition of revenue On redemption On breakage (“remote probability of redemption”) Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Accounting for Gift Cards During May 2018, Great Buy, Inc. , sold $2 million of gift cards. Also during May, $1. 5 million of gift cards sold in prior periods were redeemed by customers, and $1 million of gift cards sold in prior periods expired unused. Journal Entry Debit To record sale of gift cards Cash Deferred gift card revenue 2, 000 To record redemption of gift cards Deferred gift card revenue Revenue—gift cards 1, 500, 000 To record expiration of gift cards Deferred gift card revenue Revenue—gift cards 1, 000 Credit 2, 000 1, 500, 000 1, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Collections for Third Parties • Collections made from customers or employees and remitted periodically to the appropriate third parties Most Common Examples Payroll-related deductions such as: – Withholding taxes – Social Security taxes – Employee insurance – Employee contributions to retirement plans Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Collections for Third Parties (continued) Assume a state sales tax rate of 4% and local sales tax rate of 3%. A sale is made for $100. Journal Entry Debit Cash Sales revenue Sales tax payable (4% + 3%) Credit 107 100 7 × $100 = $7 (7%) Represents a liability until remitted Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Concept Check: Advances from Customers Perkins Inc. accepted an advance of $2, 400 on December 1, 2018, for providing IT helpdesk services for the following six months. Perkins estimates fulfillment of its performance obligation based on the passage of time. On December 31, 2018, Perkins will make an adjusting entry that includes a credit to revenue of: a. b. c. d. $2, 400 $2, 000 $800 $400 The correct answer is d. The Perkins journal entry would be: Deferred revenue ($2, 400 × 1/6) 400 Revenue 400 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -3 Concept Check: Gift Cards Ling, Inc. sold $30, 000 of gift cards during 2018. Also during 2018, $25, 000 of gift cards were redeemed, some of which were sold in 2018 and some of which were sold in the prior year. Ling also concluded that $2, 500 of gift cards sold in the prior year would never be redeemed, and Ling finished 2018 with a balance of $17, 500 in deferred revenue—gift cards. Ling should recognize revenue in 2018 associated with gift cards of: a. b. c. d. $30, 000 $27, 500 $25, 000 $17, 500 The correct answer is b: 2018 revenue = $25, 000 redeemed + $2, 500 broken = $27, 500 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -4 Current and Noncurrent Classification • Companies typically prefer to report an obligation as noncurrent rather than current – Noncurrent classification results in higher working capital and a higher current ratio Current Maturities of Long-Term Debt Long-term obligations Reclassified • Bonds • Notes • Lease liabilities • Deferred tax liabilities 20 -year bond Long-term liability for 19 years Current liabilities when they become payable within the upcoming year or operating cycle, if longer than a year Current liability in the 20 th year of term to maturity Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -4 Obligations Callable by the Creditor • The requirement to classify currently maturing debt as a current liability includes: – Debt that is callable (due on demand) by the creditor in the upcoming year/operating cycle, even if the debt is not expected to be called – When the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable – Debt is not yet callable but will be callable within the year if an existing violation is not corrected within a specified grace period Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

When Short-Term Obligations Are Expected to Be Refinanced LO 13 -4 • Short-term obligations that are expected to be refinanced on a long-term basis can be reported as noncurrent liabilities if two conditions are met: 1. The firm must intend to refinance on a long-term basis 2. The firm must actually have demonstrated the ability to refinance on a long-term basis • This is demonstrated by an existing refinancing agreement or actual financing prior to the issuance of financial statements Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Refinancing Short-Term Obligations LO 13 -4 Brahm Bros. Ice Cream had $12 million of notes that mature in May 2019 and also had $4 million of bonds issued in 1989 that mature in February 2019. On December 31, 2018, the company’s fiscal year-end, management intended to refinance both on a long-term basis. On February 7, 2019, the company issued $4 million of 20 -year bonds, applying the proceeds to repay the bond issue that matured that month. In early March, prior to the actual issuance of the 2018 financial statements, Brahm Bros. negotiated a line of credit with a commercial bank for up to $7 million any time during 2019. Any borrowings will mature two years from the date of borrowing. Interest is at the prime London interbank borrowing rate. ($ in 000 s) December 31, 2018 Classification Current Liabilities Notes Payable $5, 000 ($12, 000 − $7, 000) Long-Term Liabilities Notes Payable $7, 000 Bonds Payable 4, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -7 International Financial Reporting Standards— Classification of Liabilities to Be Refinanced U. S. GAAP IFRS Liabilities payable within the To be classified as long-term, coming year are classified as liabilities must be refinanced long-term liabilities if before the balance sheet date. refinancing is completed before the date of issuance of the financial statements. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -4 Concept Check: Noncurrent Bonds Kim’s Academy had $10, 000 of X bonds payable due in 2019. Prior to 12/31/2018, Kim’s refinanced $3, 000 of the X bonds with other bonds that mature in 2029. On January 15, 2019, Kim’s refinanced another $2, 000 of the X bonds with others that mature in 2026. Kim’s issued its financial statements on February 1, 2019. On February 15, 2019, Kim’s refinanced another $4, 000 of the X bonds with others that mature in 2027. In its 2018 financial statements, Kim’s should show noncurrent bonds payable of: a. $2, 000 b. $3, 000 c. $5, 000 d. $9, 000 The correct answer is c: $3, 000 refinanced prior to year-end + $2, 000 refinanced prior to issuance of the financial statements = $5, 000 classified as noncurrent Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -5 Loss Contingencies • A loss contingency is an existing, uncertain situation involving potential loss depending on a future event • Whether a contingency is accrued and reported as a liability depends on 1. The likelihood that the confirming event will occur 2. What can be determined about the amount of loss • U. S. GAAP requires that the likelihood that the future event be categorized as probable, reasonably possible, or remote Probable Event is likely to occur Reasonably possible The chance the event will occur is more than remote but less than likely Remote The chance the event will occur is slight Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -5 Concept Check: Loss Contingencies Which of the following is not true regarding loss contingencies and their disclosure? a. A loss contingency arises when there is uncertainty about whether a past event will result in future loss b. U. S. GAAP requires the likelihood of the future event be categorized as “probable, ” “reasonably possible, ” or “remote” c. Companies are required to account for a loss contingency when the event that gave rise to it occurred before the end of the fiscal year d. To be accrued and reported, the company must be able to estimate amount of loss The correct answer is c. Companies are required to account for a loss contingency when the event that gave rise to it occurred before the financial statement date, which will be after the end of the fiscal year. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Accounting Treatment of Loss Contingencies When loss contingency is accrued as a liability: Loss (or expense) ………………. …. Liability ……………………. . X, XXX When loss contingency is resolved using a noncash asset: Loss (or expense) ………………. …. Asset (or valuation account) ………………. . X, XXX Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Product Warranties and Guarantees • Most consumer products are accompanied by a guarantee, such as a quality-assurance warranty • Costs of satisfying guarantees should be estimated and recorded as expenses in the same accounting period the products are sold – This is a loss contingency • The criteria for accruing a contingent loss almost always are met for product warranties or guarantees – While we usually can’t predict the liability associated with an individual sale, prior experience makes it possible to predict reasonably accurate estimates of the total liability for a period Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Product Warranty Caldor Health, a supplier of in-home health care products, introduced a new therapeutic chair carrying a two-year warranty against defects. Estimates based on industry experience indicate warranty costs of 3% of sales during the first 12 months following the sale and 4% the next 12 months. During December 2018, its first month of availability, Caldor sold $2 million of chairs. Journal Entry During December Cash (and accounts receivable) Sales revenue Debit Credit 2, 000, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Product Warranty (continued) Journal Entry December 31, 2018 (adjusting entry) Warranty expense Estimated warranty liability Debit Credit 140, 000 [(3% + 4%) × $2, 000] When customer claims are made and costs are incurred to satisfy those claims, the liability is reduced ($61, 000 in 2019): Journal Entry Estimated warranty liability Cash, parts and supplies, etc. Debit Credit 61, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Expected Cash Flow Approach • The traditional way of measuring a warranty obligation is to report the “best estimate” of future cash flows – The method ignores the time value of money • An alternative expected cash flow approach is described by SFAC No. 7 – Incorporates specific probabilities of cash flows into the analysis • Required conditions: – When the warranty obligation spans more than one year and – We can associate probabilities with possible cash flow outcomes Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Product Warranty—Expected Cash Flow Approach Caldor Health, a supplier of in-home health care products, introduced a new therapeutic chair carrying a two-year warranty against defects. During December of 2018, its first month of availability, Caldor sold $2 million of the chairs. Industry experience indicates the following probability distribution for the potential warranty costs: Warranty Costs Probability 2019 $50, 000 20% $60, 000 50% $70, 000 30% 2020 $70, 000 20% $80, 000 50% $90, 000 30% Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Product Warranty (cont. 2) An arrangement with a service firm requires that costs for the two-year warranty period be settled at the end of 2019 and 2020. The risk-free rate of interest is 5%. Applying the expected cash flow approach, at the end of the 2018 fiscal year, Caldor would record a warranty liability (and expense) of $131, 564, calculated as follows: 2019 $50, 000 × 20% = $10, 000 $60, 000 × 50% = 30, 000 $70, 000 × 30% = 21, 000 $61, 000 2020 $70, 000 × 20% = $14, 000 $80, 000 × 50% = 40, 000 $90, 000 × 30% = 27, 000 $81, 000 ×. 95238 = $58, 095 ×. 90703 = $73, 469 $131, 564 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Product Warranty (concluded) Journal Entry December 31, 2018 (adjusting entry) Warranty expense Estimated warranty liability Debit Credit 131, 564 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Extended Warranty Contracts An extended warranty provides warranty protection beyond manufacturer’s original warranty Priced and sold separately from the warranteed product A separate performance obligation Revenue recognition • Recorded as a deferred revenue liability at the time of sale and • Recognized as revenue over the contract period Straight-line basis Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Extended Warranty Brand Name Appliances sells major appliances that carry a oneyear manufacturer’s warranty. Customers are offered the opportunity at the time of purchase to also buy a three-year extended warranty for an additional charge. On January 3, 2018, Brand Name sold a $60 extended warranty, covering years 2019, 2020, and 2021. Debit Journal Entry January 3, 2018 60 Cash (or accounts receivable) Deferred revenue—extended warranties December 31, 2019, 2020, 2021 (adjusting entries) 20 Deferred revenue—extended warranties Revenue–extended warranties ($60 ÷ 3) Credit 60 20 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Disclosure of Litigation Contingencies • Pending litigation is not unusual • Accrual of a loss from pending or ongoing litigation is rare – Outcome of litigation is highly uncertain – Loss is usually not recorded until after ultimate settlement • While companies should provide extensive disclosure of these contingent liabilities, they do not always do so Note 31: Litigation (in part) As of December 31, 2015, the Firm and its subsidiaries are defendants or putative defendants in numerous legal proceedings, including private, civil litigations and regulatory/government investigations. . The Firm believes the estimate of the aggregate range of reasonably possible losses, in excess of reserves established, for its legal proceedings is from $0 to approximately $3. 6 billion at December 31, 2015. This estimated aggregate range of reasonably possible losses is based upon currently available information for those proceedings in which the Firm believes that an estimate of reasonably possible loss can be made. For certain matters, the Firm does not believe that such an estimate can be made. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Disclosure of a Lawsuit— Las Vegas Sands Corporation LO 13 -6 • Even after a firm loses in court, it may not make an accrual Note 13: Commitments and Contingencies (in part): Litigation The Company believes that it has valid bases in law and fact to appeal these verdicts. As a result, the Company believes that the likelihood that the amount of the judgments will be affirmed is not probable, and, accordingly, that the amount of any loss cannot be reasonably estimated at this time. Because the Company believes that this potential loss is not probable or estimable, it has not recorded any reserves or contingencies related to this legal matter. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Accrual of Litigation Contingencies Cause of Loss Contingency Fiscal Year Ends Clarification Financial Statements • Subsequent events can clarify a pre-existing claim’s – Probability that a loss will occur – Estimated amount of loss Note 15: Commitments and Contingencies (in part) Legal Proceedings On December 6, 2010, Kraft commenced a federal court action against Starbucks, entitled Kraft Foods Global, Inc. v. Starbucks Corporation, in the U. S. District Court for the Southern District of New York. On November 12, 2013, the arbitrator ordered Starbucks to pay Kraft $2, 227. 5 million in damages plus prejudgment interest and attorney’s fees. We have estimated prejudgment interest, which includes an accrual through the estimated payment date, and attorneys’ fees to be approximately $556. 6 million. As a result, we recorded a litigation charge of $2, 784. 1 million in our fiscal 2013 operating results. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Accrual of Litigation Contingencies (continued) Cause of Loss Contingency Fiscal Year Ends Clarification or Clarification Financial Statements • If contingency comes into existence after fiscal year-end – No liability accrues, but description provided in notes Note 21: Subsequent events (in part) In February 2016, additional territories in North America met the criteria to be classified as held for sale. Therefore, we are required to record the related assets and liabilities at the lower of carrying value or fair value less any costs to sell based on the estimated sale price, which will result in a noncash loss of $296 million in 2016. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Unasserted Claims and Assessments • Even if a claim has yet to be made when the financial statements are issued, a contingency may warrant accrual or disclosure • A two-step process is involved: 1. Is it probable that a claim will be asserted? If the answer is “no, ” stop. If “yes, ” go on to step 2. 2. Treat the claim as if the claim has been asserted. 15. Commitments and Contingencies (in part) Asserted and Unasserted Claims—Various claims and lawsuits are pending against us and certain of our subsidiaries. We cannot fully determine the effect of all asserted and unasserted claims on our consolidated results of operations, financial condition, or liquidity. To the extent possible, we have recorded a liability where asserted and unasserted claims are considered probable and where such claims can be reasonably estimated. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -7 International Financial Reporting Standards— Loss Contingencies U. S. GAAP IFRS All accrued and possible obligations are referred to as “contingent liabilities” All accrued liabilities are referred to as “provisions” and possible obligations are referred to as “contingent liabilities” Higher threshold for “probable” Lower threshold for “probable” Uses the low end of the range to estimate the expenditure required to settle present obligation Uses the midpoint of the range to estimate the expenditure required to settle present obligation Loss contingencies are not typically discounted for time value of money If material, liabilities to be stated at present value Generally no disclosure or loss recognition on “onerous contracts” Recognizes provisions and contingencies for “onerous contracts” Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Gain Contingencies • A gain contingency is an uncertain situation that might result in a gain • Gain contingencies are not accrued – This is an example of conservatism—we record uncertain losses but not uncertain gains • Material gain contingencies are disclosed in the notes to the financial statements Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -7 International Financial Reporting Standards— Gain Contingencies U. S. GAAP IFRS Gain contingencies are never accrued Gain contingencies are accrued if future realization is “virtually certain” to occur Disclose when gain realization is “probable” but uses a higher threshold “probable” but uses a lower threshold for “probable” Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Concept Check: Extended Warranty On October 1, 2018, Majoor, Inc. sold a $480 snow blower with a $120 extended warranty. The warranty covers three years of repairs. During 2018, Majoor would recognize warranty revenue of: a. b. c. d. $120 $40 $10 $3. 33 The correct answer is c: $120 × (3 ÷ 36) = $10 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Concept Check: Litigation Claims GK, Inc. has the following outstanding litigation claims against it: • A claim of $100, 000. GK thinks it is probable it will lose the claim, and estimates the loss at $75, 000 if it occurs. • A claim of $50, 000. GK thinks it is probable it will lose the claim, but cannot estimate the amount of loss. • A claim of $10, 000. GK thinks it is reasonably possible it will lose the claim, and estimates the loss at $8, 000 if it occurs. GK should accrue a contingent liability of: a. $160, 000 b. $100, 000 c. $83, 000 The correct answer is d. The only amount that is both probable and reasonably estimable is $75, 000. d. $75, 000 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

LO 13 -6 Concept Check: Subsequent Events Portland’s Best Coffee has a litigation claim of $100, 000 against it. As of 12/31/2018, Portland considered it probable that it would lose $75, 000 on the claim. After the 2018 year-end, but before issuance of the financial statements, Portland settled the litigation for $60, 000. How much of a litigation liability should Portland show in its 12/31/2018 financial statements? a. b. c. d. $100, 000 $75, 000 $60, 000 $0 The correct answer is c. Portland should use information from the subsequent event of settlement of the litigation to help it estimate the amount of liability that should be included in its 12/31/2018 financial statements. Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Appendix 13 Payroll-Related Liabilities • Legal requirements to withhold taxes from employees’ paychecks • Legal requirements of the payroll taxes on firms • Voluntary payroll deductions of amounts payable to third parties Employees’ withholding taxes Payroll-related liabilities Voluntary deductions Employers’ payroll taxes Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Employees’ Withholding Taxes Appendix 13 • Employers are legally required to withhold – Federal and state income taxes – Social Security taxes – Withholdings from employees’ paychecks • Remitted to taxing authorities • Amount withheld varies with: – Amount of earnings – Amount of exemptions claimed by employee • Federal Insurance Contributions Act (FICA) requires employers to withhold a percentage of each employee’s earnings up to a specified maximum – Employer pays matching amount on behalf of employee – Self-employed persons pay both the employer and employee portions Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Appendix 13 Voluntary Deductions, Employers’ Payroll Taxes, and Fringe Benefits • Voluntary deductions – Include union dues, contributions to savings or retirement plans, and insurance premiums – Represent liabilities until paid to appropriate organizations • Employers’ payroll taxes – Employer’s matching amount of FICA taxes – Employer pays federal and state unemployment taxes on behalf of employees • Fringe benefits – Payment of employees’ insurance premiums and/or contributions to retirement income plans by employer Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Appendix 13 Payroll-Related Liabilities Crescent Lighting and Fixtures’ payroll for the second week in January was $100, 000. The following deductions, fringe benefits, and taxes apply: Federal income taxes to be withheld $20, 000 State income taxes to be withheld 3, 000 Medical insurance premiums (Blue Cross)— 70% paid by employer 1, 000 Employee contribution to voluntary retirement plan (Fidelity Investments)—contributions matched by employer 4, 000 Union dues (Local No. 222)—paid by employees 100 Life insurance premiums (Prudential Life)— 100% paid by employer 200 Social Security tax rate 6. 2% Medicare tax rate 1. 45% Federal unemployment tax rate (after state deduction) 0. 60% State unemployment tax rate 5. 40% Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

Appendix 13 Payroll-Related Liabilities (continued) Crescent’s journal entries to record payroll: Debit 100, 000 Salaries and wages expense Withholding taxes payable (federal income tax) Withholding taxes payable (state income tax) Social Security taxes payable (6. 2% × $100, 000) Medicare taxes payable (1. 45% × $100, 000) Payable to Blue Cross (30% × $1, 000) Payable to Fidelity Investments Payable to Local No. 222 Salaries and wages payable 13, 650 Payroll tax expense (total) Social Security taxes payable Medicare taxes payable FUTA payable (0. 6% × $100, 000) State unemployment tax payable (5. 4% × $100, 000) 4, 900 Salaries and wages expense (fringe benefits) Payable to Blue Cross (70% × $1, 000) Payable to Fidelity Investments Payable to Prudential Life Credit 3, 000 20, 000 3, 000 1, 000 6, 200 1, 450 300 4, 000 100 64, 950 6, 200 1, 450 600 5, 400 700 4, 000 200 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.

End of Chapter 13 Copyright © 2018 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of Mc. Graw-Hill Education.