Slide

13-1

Chapter Thirteen
Current Liabilities
and Contingencies

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 Chapter 13
Current Liabilities and
Contingencies

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc.

 Slide
13-3

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
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 Slide
13-4

What is a Current Liability?

LIABILITIES
LIABILITIES

Current
CurrentLiabilities
Liabilities Long-term
Long-termLiabilities
Liabilities

Generally,
Generally,payable
payablewithin
withinone
oneyear.
year.

Formally,
Formally,expected
expectedtotobe
besatisfied
satisfied
with
withcurrent
currentassets
assets(or
(orbybythe
the
creation
creationof
ofother
othercurrent
currentliabilities).
liabilities).

Conceptually,
Conceptually,should
shouldbe berecorded
recordedat atpresent
present
value,
value, but
but ordinarily
ordinarily are
are reported
reported at
at maturity
maturity
amounts.
amounts.
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 GENERAL MILLS, INC.
Slide
13-5

BALANCE SHEET
MAY 29, 2011 AND MAY 30, 2010
($ in millions)
ASSETS
[BY CLASSIFICATION]

LIABILITIES

Current Liabilities: 2011 2010

Accounts payable $ 995$ 850
Current portion of long-term debt 1,031 107
Notes payable 311 1,050
Other current liabilities 1,322 1,762
Total current liabilities $3,659$3,769
Long-term Liabilities:
[LISTED INDIVIDUALLY]

Shareholders’ equity
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 Slide
13-6

8: Notes Payable
The components of notes payable and their respective weighted
average interest rates at the end of the period are as follows:
2011 2010
Weighted Weighted
Dollars in millions: Average Average
Note Interest Note Interest
Payable Rate Payable Rate
U.S. commercial paper $192 .2% $ 973 .3%
Financial institutions 119 11.5 77 10.6
Total notes payable $311 $1,050

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 Slide
13-7

8: Notes Payable (cont.)

To ensure availability of funds, we maintain bank
credit lines sufficient to cover our outstanding short-
term borrowings. Our commercial paper borrowings
are supported by $2.9 billion of fee-paid committed
credit lines, consisting of a $1.8 billion facility
expiring in October 2012 and a $1.1 billion facility
expiring in October 2013. We also have $311.8million
in uncommitted lines which support our foreign
operations.

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 Slide
13-8

Interest
Interest on notes is calculated as :

Amount
Amount Interest
Interestrate
rateis
is Interest
Interestowed
owed is is
borrowed
borrowed always
always stated
stated adjusted
adjustedfor forthe
the
as
asan
anannual
annual portion
portion ofof the
theyear
year
rate.
rate. that
thatthe
thedebt
debtisis
outstanding.
outstanding.

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 Slide
13-9

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
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 Slide
13-10

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
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 Slide
13-11

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 Interest
Interestis
iscalculated
calculatedas:
as:
b. $ 3,600 Face Annual Time
Face Annual Timeto to
c. $ 7,200 Amount × Rate × maturity =
Amount Rate maturity
d. $87,200
$80,000
$80,000 × 9% 9% × 4/124/12 =

$2,400
$2,400interest.
interest.
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 Slide
13-12

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 42,000
Discount on notes 42,000

Notes payable (face amount) 700,000

Cash 700,000
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 Slide
13-13

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
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 Slide
13-14

ACCRUED LIABILITIES
 Liabilities accrue for expenses 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.

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 Slide
13-15

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 700,000
Note payable 700,000

Accrual of interest on June 30

Interest expense ($700,000 x 12% x 2/12) 14,000
Interest 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 700,000
Cash ($700,000 + 42,000) 742,000
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 Slide
13-16

Liabilities from Advance

Collections
 Refundable Deposits
 Advances from
Customers
 Collections for Third
Parties

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 Slide
13-17

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
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 Slide
13-18

Short-Term Obligations
Expected to Be Refinanced
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 the ability to do so:

byactual
by actualfinancing
financing(prior
(priorto
tothe
by
byeither
eitheran
refinancing
anexisting
existing
refinancingagreement
agreement
or issuance
issuanceofofthe
thefinancial
financial
the

statements)
statements)

 The specific form of the long-term refinancing (bonds,

bank loans, equity securities) is irrelevant.
 The concept of substance over form.
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 Slide
13-19

Contingencies
AA loss
loss contingency
contingency isis an
an
existing
existing uncertain
uncertain
situation
situation involving
involving
potential
potential loss
loss
depending
depending on on whether
whether
some
some future
future event
event
occurs.
occurs.
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 Slide
13-20

Contingencies
Two
Two factors
factors affect
affect whether
whether aa loss
loss
contingency
contingency mustmust be be accrued
accrued and
and
reported
reported asas aa liability:
liability:
1.
1. the
the likelihood
likelihood that
that the
the confirming
confirming
event
event will
will occur.
occur.
2.
2. whether
whether thethe loss
loss amount
amount can can be
be
reasonably
reasonably estimated.
estimated.

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 Slide
13-21

Contingencies – Likelihood of
Occurrence
 Probable
Probable
 AA confirming
confirming event
event isis likely
likely to
to occur.
occur.
 Reasonably
Reasonably Possible
Possible
 The
The chance
chance the
the confirming
confirming event
event will
will occur
occur
isis >
> remote,
remote, but
but << likely.
likely.
 Remote
Remote
 The
The chance
chance the
the confirming
confirming event
event will
will occur
occur
isis slight.
slight.

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 Slide
13-22

Loss Contingencies
Accounting Treatments

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 Slide
13-23

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 2013, 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, 2013 (adjusting entry)

Warranty expense ([3% + 4%] x $2,000,000) 140,000
Estimated warranty liability 140,000
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 Slide
13-24

Subsequent Events
If
Ifinformation
informationbecomes
becomesavailable
availablethat
thatsheds
shedslight
lighton
onaa
contingency
contingencythatthatexisted
existedwhen
whenthethefiscal
fiscalyear
yearended,
ended,that
that
information
informationshould
shouldbebeused
usedinindetermining
determiningthe theprobability
probability
of
of a loss contingency materializing and in estimatingthe
a loss contingency materializing and in estimating the
amount of the loss.
amount of the loss.

Cause of Loss Contingency Clarification

Fiscal Year Ends Financial Statements

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 Slide
13-25

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 EPA is in the process of investigating the

possibility of environmental violations at a company’s site, but
has not proposed a penalty 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) the likelihood 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.
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 Slide
13-26

Gain Contingencies

Desirable to anticipate losses,

but recognizing gains should
await their realization.

 Should be disclosed in notes

As a general rule, we to the financial statements.
never record GAIN  Care should be taken that
contingencies. the disclosure note not give
"misleading implications as to
the likelihood of realization."
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 Slide
13-27

End of Chapter 13

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