Financial accounting in an economic context 8e chapter 010

Reporting Liabilities on the Balance Sheet: Economic Consequences  Shareholders and investors – interest expense is tax deductible, but more debt means more risk to shareholders – equi

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transactions or events.”

Liabilities

Reporting Liabilities on the Balance Sheet:

Economic Consequences

 Shareholders and investors

– interest expense is tax deductible, but more debt means more risk to shareholders

– equity ownership is subordinated to creditors

 Creditors

– restrictive covenants regarding debt limits

 Management

– wants to minimize debt on the balance sheet

– often looks for “off-balance sheet” financing

– less debt now improves ability to borrow in the future

Current Liabilities

Current Liabilities

 Classification

– expected to require the use of current assets (or the

creation of other current liabilities) to settle the

obligation

 Valuing current liabilities on the balance sheet

– Ignore present value (report at face value)

 Reporting current liabilities

– Primary problem is ensuring that all existing current

liabilities are reported on the balance sheet

Figure 10-3

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Determinable Current Liabilities

6 Sales tax payable

7 Income taxes payable (App 10B)

8 Payroll taxes payable

Determinable CL - continued

Accrued liabilities - accrue expense and liability

at the end of the current period, and usually

paid sometime during the next year For each item, debit expense and credit liability

Incentive Compensation

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Contingent Liabilities

 Contingent on some future event or activity in order

to know the exact amount

Examples: warranties, coupons and lawsuits

 Changes in estimate may be made in subsequent

periods, when future event is concluded.

 Under IFRS, much of these transactions are reported

in a balance sheet account called “provisions”.

– Provisions are more readily booked than contingent liabilities because IFRS provisions are accrued when the obligation is

“more likely than not,” while under US GAAP contingent liabilities are accrued when “highly probable,” which is a much higher

threshold.

Figure 10-5

Contingent Liabilities

Warranties

– Uncertain future costs

– Record estimated expense and liability when products

are sold (matching concept):

Estimated Warranty Liability xx

– As costs are incurred (usually in subsequent periods), charge expenditure to warranty liability:

Estimated Warranty Liability xx

Class Problem: P10-4, Parts a & b:

Issues and recommendations:

Class Problem: P10-4, Part c:

Adjusting journal entry for 2011:

Estimated loss 742,000

Estimated liability 742,000

(Best guess in the range)

Journal entry at settlement (8/12/12):

Estimated liability 742,000

Recovery of estimated loss 52,000

Cash 690,000

Class Exercise: E10-10(a)

(1) GJE to record sale in 2011 (200 @ $250 each):

Estimated Warr Liability 4,000

(3) GJE to record payment in 2011 for repairs:

Est Warr Liability 1,400

GJE to record payment in 2012 for repairs:

Est Warr Liability 2,600

Class Exercise: E10-10(b)

Income effects for the revenue and warranty

expense under the two alternative for recognition

of expense (expressed in thousands):

Accrue Expense Expense as Paid

2011 2012 2011 2012 Revenues 50,000 - 50,000 -

Warr Expense (4,000) - (1,400) (2,600)

Note that the accrual method recognizes the

expense in the same period as the revenues

generated by the sale.

Retirement Costs (App 10A)

 Defined Contribution Plans

– Less expensive than Defined Benefit Plans

 Defined Benefit Plans

– Benefits must be predicted, therefore several assumptions and estimates are required

– Social Security is form of Defined Benefit Plan

– The entry to record the estimated liability is simple, but the calculations can be quite complicated:

Dr Pension Expense

Cr Pension Liability

Deferred Taxes (App 10B)

 Generated by the discrepancy between income

and expenses for taxation (specified by IRS) and financial reporting (specified by GAAP).

Example:

– Equipment purchased on 1/1/09 for $9,000

– 3-year useful life

– no salvage value

– DDB for income tax purposes

– SL for financial reporting purposes

– Income tax rate of 30%

Depreciation Schedules

2009 Deferred income tax liability $900

2010 Deferred income tax benefit $300

2011 Deferred income tax benefit $600

Deferred Income Tax Liability

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The Conservatism Ratio

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The Conservatism Ratio

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