Ch 13 Current Liabilties Q-A

Question 1

Distinguish between a current liability and a long-term debt.

Answer 1

Current liabilities are obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities. Long-term debt consists of all liabilities not properly classified as current liabilities.

Question 2

Assume that your friend Will Morris, who is a music major, asks you to define and discuss the nature of a liability. Assist him by preparing a definition of a liability and by explaining to him what you believe are the elements or factors inherent in the concept of a liability.

Answer 2

You might explain to your friend that the accounting profession at one time prepared financial statements somewhat in accordance with the broad or loose definition of a liability submitted by the AICPA in 1953: ?Something represented by a credit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting, provided such credit balance is not in effect a negative balance applicable to an asset. Thus the word is used broadly to comprise not only items which constitute liabilities in the proper sense of debts or obligations (including provision for those that are unascertained), but also credit balances to be accounted for which do not involve the debtor and creditor relation.? Since your friend may not have completely understood the above definition (if it may be called that), you might indicate that more recent definitions of liabilities call for the disbursement of assets or services in the future and that the present value of all of a person?s or company?s future disbursements of assets constitutes the total liabilities of that person or company. But, accountants quantify or measure only those liabilities or future disbursements which are reasonably determinable at the present time. And, accountants have accepted the completed transaction as providing the objectivity or basis necessary for financial recognition. Therefore, a liability may be viewed as an obligation to convey assets or perform services at some time in the future and is based upon a past or present transaction or event. A formal definition of liabilities presented in Concepts Statement No. 6 is as follows: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Question 3

Why is the liabilities section of the balance sheet of primary significance to bankers?

Answer 3

As a lender of money, the banker is interested in the priority his/her claim has on the company?s assets relative to other claims. Close examination of the liability section and the related footnotes discloses amounts, maturity dates, collateral, subordinations, and restrictions of existing contractual obligations, all of which are important to potential creditors. The assets and earning power are likewise important to a banker considering a loan.

Question 4

How are current liabilities related by definition to current assets? How are current liabilities related to a company?s operating cycle?

Answer 4

Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets, or the creation of other current liabilities. Because current liabilities are by definition tied to current assets and current assets by definition are tied to the operating cycle, liabilities are related to the operating cycle.

Question 5

Leon Wight, a newly hired loan analyst, is examining the current liabilities of a corporate loan applicant. He observes that unearned revenues have declined in the current year compared to the prior year. Is this a positive indicator about the client?s liquidity? Explain.

Answer 5

Unearned revenue is a liability that arises from current sales but for which some services or products are owed to customers in the future. At the time of a sale, customers pay not only for the delivered product, but they also pay for future products or services (e.g., another plane trip, hotel room, or software upgrade). In this case, the company recognizes revenue from the current product and part of the sale proceeds is recorded as a liability (unearned revenue) for the value of future products or services that are ?owed? to customers. Market analysts indicate that an increase in the unearned revenue liability, rather than raising a red flag, often provides a positive signal about sales and profitability. When the sales are growing, its unearned revenue account should grow. Thus, an increase in a liability may be good news about company performance. In contrast, when unearned revenues decline, the company owes less future amounts but this also means that sales of new products may have slowed.

Question 6

How is present value related to the concept of a liability?

Answer 6

Payables and receivables generally involve an interest element. Recognition of the interest element (the cost of money as a factor of time and risk) results in valuing future payments at their current value. The present value of a liability represents the debt exclusive of the interest factor.

Question 7

What is the nature of a ?discount? on notes payable?

Answer 7

A discount on notes payable represents the difference between the present value and the face value of the note, the face value being greater in amount than the discounted amount. It should be treated as an offset (contra) to the face value of the note and amortized to interest expense over the life of the note. The discount represents interest expense chargeable to future periods.

Question 8

How should a debt callable by the creditor be reported in the debtor?s financial statements?

Answer 8

Liabilities that are due on demand (callable by the creditor) should be classified as a current liability. Classification of the debt as current is required because it is a reasonable expectation that existing working capital will be used to satisfy the debt. Liabilities often become callable by the creditor when there is a violation of the debt agreement. Only if it can be shown that it is probable that the violation will be cured (satisfied) within the grace period usually given in these agreements can the debt be classified as noncurrent.

Question 9

Under what conditions should a short-term obligation be excluded from current liabilities?

Answer 9

An enterprise should exclude a short-term obligation from current liabilities only if (1) it intends to refinance the obligation on a long-term basis, and (2) it demonstrates an ability to consummate the refinancing.

Question 10

What evidence is necessary to demonstrate the ability to consummate the refinancing of short-term debt?

Answer 10

The ability to consummate the refinancing may be demonstrated (i) by actually refinancing the short- term obligation by issuing a long-term obligation or equity securities after the date of the balance sheet but before it is issued, or (ii) by entering into a financing agreement that clearly permits the company to refinance the debt on a long-term basis on terms that are readily determinable.

Question 11

Discuss the accounting treatment or disclosure that should be accorded a declared but unpaid cash dividend, an accumulated but undeclared dividend on cumulative preferred stock, and a stock dividend distributable.

Answer 11

A cash dividend formally authorized by the board of directors would be recorded by a debit to Retained Earnings and a credit to Dividends Payable. The Dividends Payable account should be classified as a current liability. An accumulated but undeclared dividend on cumulative preferred stock is not recorded in the accounts as a liability until declared by the board, but such arrearages should be disclosed either by a footnote to the balance sheet or parenthetically in the capital stock section. A stock dividend distributable, formally authorized and declared by the board, does not appear as a liability because a stock dividend does not require future outlays of assets or services and is revocable by the board prior to issuance. Even so, an undistributed stock dividend is generally reported in the stockholders? equity section since it represents retained earnings in the process of transfer to paid-in capital.

Question 12

How does unearned revenue arise? Why can it be classified properly as a current liability? Give several examples of business activities that result in unearned revenues.

Answer 12

Unearned revenue arises when a company receives cash or other assets as payment from a customer before conveying (or even producing) the goods or performing the services which it has committed to the customer. Unearned revenue is assumed to represent the obligation to the customer to refund the assets received in the case of nonperformance or to perform according to the agreement and thus earn the unrestricted right to the assets received. While there may be an element of unrealized profit included among the liabilities when unearned revenues are classified as such, it is ignored on the grounds that the amount of unrealized profit is uncertain and usually not material relative to the total obligation. Unearned revenues arise from the following activities: (1) The sale by a transportation company of tickets or tokens that may be exchanged or used to pay for future fares. (2) The sale by a restaurant of meal tickets that may be exchanged or used to pay for future meals. (3) The sale of gift certificates by a retail store. (4) The sale of season tickets to sports or entertainment events. (5) The sale of subscriptions to magazines.

Question 13

What are compensated absences?

Answer 13

Compensated absences are employee absences such as vacation, illness, and holidays for which it is expected that employees will be paid.

Question 14

Under what conditions must an employer accrue a liability for the cost of compensated absences?

Answer 14

A liability should be accrued for the cost of compensated absences if all of the following conditions are met: (a) The employer?s obligation relating to employees? rights to receive compensation for future absences is attributable to employees? services already rendered. (b) The obligation relates to the rights that vest or accumulate. (c) Payment of the compensation is probable. (d) The amount can be reasonably estimated. If an employer meets conditions (a), (b), and (c), but does not accrue a liability because of failure to meet condition (d), that fact should be disclosed.

Question 15

Under what conditions is an employer required to accrue a liability for sick pay? Under what conditions is an employer permitted but not required to accrue a liability for sick pay?

Answer 15

An employer is required to accrue a liability for ?sick pay? that employees are allowed to accumu-late and use as compensated time off even if their absence is not due to illness. An employer is permitted but not required to accrue to liability for sick pay that employees are allowed to claim only as a result of actual illness.

Question 16

Faith Battle operates a health food store, and she has been the only employee. Her business is growing, and she is considering hiring some additional staff to help her in the store. Explain to her the various payroll deductions that she will have to account for, including their potential impact on her financial statements, if she hires additional staff.

Answer 16

Employers generally withhold from each employee?s wages amounts to cover income taxes (withholding), the employee?s share of FICA taxes, and other items such as union dues or health insurance. In addition, the employer must set aside amounts to cover the employer?s share of FICA taxes and state and federal unemployment taxes. These latter amounts are recorded as payroll expenses and will lower Battle?s income. In addition, the amount set aside (both the employee and the employer share) will be reported as current liabilities until they are remitted to the appropriate third party.

Question 17

Define (a) a contingency and (b) a contingent liability.

Answer 17

(a) A contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. (b) A contingent liability is a liability incurred as a result of a loss contingency.

Question 18

Under what conditions should a contingent liability be recorded?

Answer 18

A contingent liability should be recorded and a charge accrued to expense only if: (a) information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements, and (b) the amount of the loss can be reasonably estimated.

Question 19

Distinguish between a determinable current liability and a contingent liability. Give two examples of each type.

Answer 19

A determinable current liability is susceptible to precise measurement because the date of payment, the payee, and the amount of cash needed to discharge the obligation are reasonably certain. There is nothing uncertain about (1) the fact that the obligation has been incurred and (2) the amount of the obligation. A contingent liability is an obligation that is dependent upon the occurrence or nonoccurrence of one or more future events to confirm the amount payable, the payee, the date payable, or its existence. It is a liability dependent upon a ?loss contingency.? Determinable current liabilities?accounts payable, notes payable, current maturities of long-term debt, dividends payable, returnable deposits, sales and use taxes, payroll taxes, and accrued expenses. Contingent liabilities?obligations related to product warranties and product defects, premiums offered to customers, certain pending or threatened litigation, certain actual and possible claims and assessments, and certain guarantees of indebtedness of others.

Question 20

How are the terms ?probable,? ?reasonably possible,? and ?remote? related to contingent liabilities?

Answer 20

The terms probable, reasonably possible, and remote are used in GAAP to denote the chances of a future event occurring, the result of which is a gain or loss to the enterprise. If it is probable that a loss has been incurred at the date of the financial statements, then the liability (if reasonably estimable) should be recorded. If it is reasonably possible that a loss has been incurred at the date of the financial statements, then the liability should be disclosed via a footnote. The footnote should disclose (1) the nature of the contingency and (2) an estimate of the possible loss or range of loss or a statement that an estimate cannot be made. If the incurrence of a loss is remote, then no liability need be recorded or disclosed (except for guarantees of indebtedness of others, which are disclosed even when the loss is remote).

Question 21

Contrast the cash-basis method and the accrual method of accounting for warranty costs.

Answer 21

Under the cash-basis method, warranty costs are charged to expense in the period in which the seller or manufacturer performs in compliance with the warranty, no liability is recorded for future costs arising from warranties, and the period of sale is not necessarily charged with the costs of making good on outstanding warranties. Under the accrual method, a provision for warranty costs is made at the time of sale or as the productive activity takes place; the accrual method may be applied two different ways: expense warranty versus sales warranty method. But under either method, the attempt is to match warranty expense to the related revenues.

Question 22

Grant Company has had a record-breaking year in terms of growth in sales and profitability. However, market re- search indicates that it will experience operating losses in two of its major businesses next year. The controller has proposed that the company record a provision for these future losses this year, since it can afford to take the charge and still show good results. Advise the controller on the appropriateness of this charge.

Answer 22

Under U.S. GAAP, companies may not record provisions for future operating losses. Such provi-sions do not meet the definition of a liability, since the amount is not the result of a past transaction (the losses have not yet occurred). Therefore the liability has not been incurred. Furthermore, operating losses reflect general business risks for which a reasonable estimate of the loss could not be determined. Note that use of provisions in this way is one of the examples of earnings management discussed in Chapter 4. By reducing income in good years through the use of loss contingencies, companies can smooth out their income from year-to-year.

Question 23

How does the expense warranty approach differ from the sales warranty approach?

Answer 23

The expense warranty approach and the sales warranty approach are both variations of the accrual method of accounting for warranty costs. The expense warranty approach charges the estimated future warranty costs to operating expense in the year of sale or manufacture. The sales warranty approach defers a certain percentage of the original sales price until some future time when actual costs are incurred or the warranty expires.

Question 24

Southeast Airlines Inc. awards members of its Flightline program a second ticket at half price, valid for 2 years anywhere on its flight system, when a full-price ticket is purchased. How would you account for the full-fare and half-fare tickets?

Answer 24

Southeast Airlines Inc.?s award plan is in essence a discounted ticket sale. Therefore, the full-fare ticket should be recorded as unearned transportation revenue (liability) when sold and recognized as revenue when the transportation is provided. The half-fare ticket should be treated accordingly; that is, record the discounted price as unearned transportation revenue (liability) when it is sold and recognize it as revenue when the transportation is provided.

Question 25

Pacific Airlines Co. awards members of its Frequent Fliers Club one free round-trip ticket, anywhere on its flight system, for every 50,000 miles flown on its planes. How would you account for the free ticket award?

Answer 25

Although the accounting for this transaction has been studied, no authoritative guideline has been developed to record this transaction. In the case of a free ticket award, AcSEC proposed that a portion of the ticket fares contributing to the accumulation of the 50,000 miles (the free ticket award level) be deferred as unearned transportation revenue and recognized as revenue when free transportation is provided. The total amount deferred for the free ticket should be based on the revenue value to the airline and the deferral should occur and accumulate as mileage is accumulated.

Question 26

When must a company recognize an asset retirement obligation?

Answer 26

An asset retirement obligation must be recognized when a company has an existing legal obligation associated with the retirement of a long-lived asset and when the amount can be reasonably estimated.

Question 27

Should a liability be recorded for risk of loss due to lack of insurance coverage? Discuss.

Answer 27

The absence of insurance does not mean that a liability has been incurred at the date of the financial statements. Until the time that an event (loss contingency) occurs there can be no diminution in the value of property or incurrence of a liability. If an event has occurred which exposes an enterprise to risks of injury to others and/or damage to the property of others, then a contingency exists. Expected future injury, damage, or loss resulting from lack of insurance need not be recorded or disclosed if no contingency exists. And, a contingency exists only if an uninsurable event which causes probable loss has occurred. Lack of insurance is not in itself a basis for recording a liability or loss.

Question 28

What factors must be considered in determining whether or not to record a liability for pending litigation? For threatened litigation?

Answer 28

In determining whether or not to record a liability for pending litigation, the following factors must be considered: (a) The time period in which the underlying cause for action occurred. (b) The probability of an unfavorable outcome. (c) The ability to make a reasonable estimate of the amount of loss. Before recording a liability for threatened litigation, the company must determine: (a) The degree of probability that a suit may be filed, and (b) The probability of an unfavorable outcome. If both are probable, the loss reasonably estimable, and the cause for action dated on or before the date of the financial statements, the liability must be accrued.

Question 29

Within the current liabilities section, how do you believe the accounts should be listed? Defend your position.

Answer 29

There are several defensible recommendations for listing current liabilities: (1) in order of maturity, (2) according to amount, (3) in order of liquidation preference. The authors? recent review of published financial statements disclosed that a significant majority of the published financial statements examined listed ?notes payable? first, regardless of relative amount, followed most often by ?accounts payable,? and ending the current liability section with ?current portion of long-term debt.?

Question 30

How does the acid-test ratio differ from the current ratio? How are they similar?

Answer 30

The acid-test ratio and the current ratio are both measures of the short-term debt-paying ability of the company. The acid-test ratio excludes inventories and prepaid expenses on the basis that these assets are difficult to liquidate in an emergency. The current ratio and the acid-test ratio are similar in that both numerators include cash, short-term investments, and net receivables, and both denominators include current liabilities.

Question 31

When should liabilities for each of the following items be recorded on the books of an ordinary business corporation?

Answer 31

(a) A liability for goods purchased on credit should be recorded when title passes to the purchaser. If the terms of purchase are f.o.b. destination, title passes when the goods purchased arrive; if f.o.b. shipping point, title passes when shipment is made by the vendor. (b) Officers? salaries should be recorded when they become due at the end of a pay period. Accrual of unpaid amounts should be recorded in preparing financial statements dated other than at the end of a pay period. (c) A special bonus to employees should be recorded when approved by the board of directors or person having authority to approve, if the bonus is for a period of time and that period has ended at the date of approval. If the period for which the bonus is applicable has not ended but only a part of it has expired, it would be appropriate to accrue a pro rata portion of the bonus at the time of approval and make additional accruals of pro rata amounts at the end of each pay period. (d) Dividends should be recorded when they have been declared by the board of directors. (e) Usually it is neither necessary nor proper for the buyer to make any entries to reflect commitments for purchases of goods that have not been shipped by the seller. Ordinary orders, for which the prices are determined at the time of shipment and subject to cancellation by the buyer or seller, do not represent either an asset or a liability to the buyer and need not be reflected in the books or in the financial statements. However, an accrued loss on purchase commitments which results from formal purchase contracts for which a firm price is in excess of the market price at the date of the balance sheet would be shown in the liability section of the balance sheet. (See Chapter 9 on purchase commitments.)