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QUESTIONS FOR REVIEW OF KEY TOPICS A liability entails the present, the future, and the past. It is a present responsibility, to sacrifice This is proper because of the time value of money. In practice, liabilities ordinarily are reported at maturity amounts if payable within one year because th e relatively short time period makes the interest or time value component immaterial. Accounting Principles Board Opinion No 21 Receivables and Payables,” specifically exempts from present value valuation all liabilities arising in connection with suppliers in the normal course of business and due within a year. Lines of credit permit a company to borrow cas h from a bank up to a prearranged limit at a When interest is “discounted” from the face amount of a note at the time it is written, it usually is referred to as a “noninterest-bearing” note. They do, of course entail interest, but the interest is deducted (or discounted) from the face amount to de termine the cash proceeds made available to the includes debt that is , or due on demand, by the creditor in the upcoming year even if the Long-term liability — The current liability classification includes (a) situations in which the creditor has the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in wh The contingent liability for warranties and guarant ees usually is accrued. The estimated warranty (guarantee) liability is credited and warranty (guarantee) expense is debited in the reporting period in which the product under warranty is sold. An ex the manufacturer’s original warranty. A manufacturer’s warranty is offered as an integral part of the product package. By contrast, an extended warranty is priced and sold separately from the warranted When an assessment is probable, reporting the possible obligation would be warranted if an Cash ............................................................................ 8,000,000 Notes payable......................................................... 8,000,000 ).............. 160,000 Interest payable...................................................... 160,000 ).............. 560,000 Interest payable (from adjusting entry)...................... 160,000 Notes payable (face amount)...................................... 8,000,000 Cash (total)............................................................. 8,720,000 )*......................... 600,000 Discount on notes payable ................................................. 600,000 Notes payable (balance).......................................................... 10,000,000 Cash (maturity amount)...................................................... 10,000,000 Liability – gift certificates ................................................... 5,200 Cash ($2,100 + 84 - 1,300)....................................................... 884 Liability – gift certificates ........................................................ 1,300 Sales revenue........................................................................ 2,100 Sales taxes payable (4% x $2,100)....................................... 84 Gift certificates sold $5,200 Gift certificates redeemed 1,300 Liability to be reported at December 31 $3,900 Gift certificates sold $5,200 x 80 Estimated current liability $4,160 Gift certificates redeemed (1,300) Current liability at December 31 $2,860 Noncurrent liability at December 31 ($5,200 x 20%) 1,040 Total $3,900 Cash.................................................................................... 7,500 Liability – customer advance ........................................ 7,500 Cash.................................................................................... 25,500 Liability – refundable deposits ..................................... 25,500 Accounts receivable............................................................ 856,000 Sales revenue ................................................................ 800,000 Sales taxes payable ([5% + 2%] x $800,000)................ 56,000 Normally, short-term debt (payable within a year) is classified as current liabilities. However, when such debt is to be refinanced on a long-term basi s, it may be included with long-term liabilities. The narrative indicates that Sprint has both (1) the in tent and (2) the ability ("existing long-term credit facilities") to refinance on a long-term basis. Thus, Sprint reported the debt as long-term liabilities. This is a loss contingency. There may be a fu ture sacrifice of econom ic benefits (cost of satisfying the warranty) due to an existing circum stance (the warranted awnings have been sold) that depends on an uncertain future event (customer claims). The liability is probable because product warranties inevitably entail costs. A reasonably accurate estimate of the total liability for a period is possible based on prior experience. So, the contingent liability for the warranty is accrued. The estimated warranty liability is credited and Accounts receivable......................................................... 5,000,000 Sales ............................................................................ 5,000,000 Warranty expense (3% x $5,000,000)............................. 150,000 Estimated warranty liability ....................................... 150,000 Estimated warranty liability ............................................ 37,500 150,000 Estimated liability Actual expenditures 37,500 112,500 Balance Warranty expense ([4% x $2,000,000] - $30,800).................. 49,200 Estimated warranty liability ............................................... 49,200 Bad debt expense (2% x $2,000,000)...................................... 40,000 Allowance for uncollectible accounts ................................ 40,000 This is a loss contingency. Classical can us e the information occurring after the end of the 1. Commercial paper. N. Not reported __D_ 2. Noncommitted line of credit. C. Current liability __C_ 3. Customer advances. L. Long-term liability __C_ 4. Estimated warranty cost. D. Disclosure note only __C_ 6. Long-term bonds that will be callable by th e creditor in the upcoming year unless an existing violation is not corrected (there is a reasonable possibility the violation will be __C_ 7. Note due March 3, 2004. __C_ 8. Interest accrued on note, Dec. 31, 2003. __L_ 9. Short-term bank loan to be paid with proceeds of sale of common stock. __D_ 11. Unasserted assessment of back taxes that probably will be asserted, in which case there would probably be a loss in six months. __N_ 12. Unasserted assessment of back taxes with a reasonable possibility of being asserted, in which case there would probably be a loss in 13 months. __C_ 14. Bond sinking fund. __C_ 15. Long-term bonds callable by the creditor in the upcoming year that are not expected to be The note describes a loss contingency. Dow anticip ates a future sacrifice of economic benefits (cost of remediation and restoration) due to an existing circumstance (environmental violations) that depends on an uncertain future event (requirement to pay claim). Dow considers the liability probable and the amount is reasonably estimable. As a result, the company accrued the liability: ($ in millions) Loss provision from environmental claims................................ 325 e. Interest expense ($12,000,000 x 10% x )................. 300,000 Interest payable......................................................... 300,000 f. Cash ................................................................................. 10,000,000 Bonds payable............................................................ 10,000,000 Interest expense ($12,000,000 x 10% x )................. 200,000 Interest payable (from adjusting entry)........................... 300,000 Notes payable (face amount)........................................... 12,000,000 Cash ($12,000,000 + 500,000)................................... 12,500,000 g. Liability – refundable deposits ....................................... 1,300 Cash............................................................................ 1,300 Accounts payable $ 252,000 Current portion of bank loan 2,000,000* Liability – refundable deposits 2,600 Sales taxes payable 246,000 Accrued interest payable 300,000 $2,800,600 Bank loan to be refinanced on a long-term basis $10,000,000* * The intent of management is to refinance all $12,000,000 of the bank loan, but the actual refinancing demonstrates the a. The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year – even if the debt is not expected to be called. So, the entire $40 million debt is a current liability. b. $5 million can be reported as long term, but $1 m illion must be reported as a current liability. Short-term obligations that are expected to be refinanced with long-term obligations can be reported as noncurrent liabilities only if the firm (a) to refinance on a long-term basis and (b) actually has demonstrated the ability to do so. Ability to refinance on a long-term basis can be demonstrated by either an existing or by actual financing prior to the issuance of the financial statements. The refinancing agreement in this case limits the ability to refinance to $5 million of the notes. In the absence of other evidence of ability to refinance, the remaining $1 million cannot be reported as long term. c. The entire $20 million maturity amount should be reported as a current liability because that amount is payable in the upcoming year and it will not be refinanced with long-term obligations d. The entire $12 million loan should be reported as a long-term liability because that amount is payable in 2006 and it will not be refinanced w ith long-term obligations nor paid with a bond sinking fund. The current liability classification in the right to demand payment because an existing violation of a provision of the debt agreement makes it callable and (b) situations in which debt 11% bonds due October 31, 2014, redeemable on October 31, 2004 $40 12% bonds due September 30, 2004 20 60 83 Long-Term Debt Currently maturing debt classified as long-term: 10% notes payable due May 2004 (Note X) 5 9% bank loan due October 2009 12 Total Long-Term Liabilities 17 $100 The Company intends to refinance $6 million of 10% notes that mature in May of 2004. In March, 2004, the Company negotiated a line of credit with a commercial bank for up to $5 million any time during 2004. Any borrowings will mature two years from the date of borrowing. Accordingly, $5 million was reclassified to long-term liabilities. a. This is a loss contingency. Eastern can use the information occurring after the end of the year in million loss because the judgment will be appealed and that outcome is uncertain. A disclosure In a lawsuit resulting from a dispute with a s upplier, a judgment was rendered against Eastern Corporation in the amount of $107 million plus inte rest, a total of $122 million at February 3, 2004. Eastern plans to appeal the judgment. While mana gement and legal counsel are presently unable to predict the outcome or to estimate the amount of any liability the company may have with respect to this lawsuit, it is not expected that this matter will have a material adverse effect on the company. b. This is a loss contingency. Eastern can use the information occurring after the end of the year in In November 2002, the State of Nevada filed suit against the Company, seeking civil penalties and injunctive relief for violations of environmental laws regulating hazardous waste. On January 12, Based upon discussions with legal counsel, the Co mpany, has accrued and charged to operations in 2003, $140 million to cover the anticipated cost of a ll violations. The Company believes that the c. This is a gain contingency. Gain contingencie s are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. Though gain contingencies are not recorded in the accounts, they should be disclosed in notes to the financial statements. Eastern is the plaintiff in a pending lawsuit filed ag ainst United Steel for damages due to lost profits from rejected contracts and for unpaid receivables. The case is in final appeal. No amount has been accrued in the financial statements for possible collection of any claims in this litigation. d. No disclosure is required because an IRS clai List A List B j _ 1. Face amount x Interest rate x Time a. Informal agreement g 3. Short-term debt to be refinanced c. Refinancing prior to the issuance with common stock of the financial statements i _ 4. Present value of interest plus d. Accounts payable present value of principal e. Accrued liabilities d 5. Noninterest-bearing f. Commercial paper a 6. Noncommitted line of credit g. Current liabilities b _ 7. Pledged accounts receivable h. Long-term liability c _ 8. Reclassification of debt i. Usual valuation of liabilities f _ 9. Purchased by other corporations j. Interest on debt e _ 11. Liability until refunded l. Customer deposits k _ 12. Applied against purchase price Mitch Riley Your Name Accounting for contingencies Below is a brief overview of my initial thought s on how Western should account for the four 1. The labor disputes constitute a loss contingenc y. Though a loss is probable, the amount of loss is not reasonably estimable. A disclosure note is appropriate: During 2003, the Company experienced labor disput es at three of its plants. The Company hopes an agreement will soon be reached. Ho these facilities. 2. The A. J. Conner matter is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. Though gain contingencies are not recorded in th e accounts, they should be disclosed in notes to the financial statements. In accordance with a 2001 contractual agreement with A.J. Conner Company, the Company is entitled to $37 million for certain fees and expens e reimbursements. The bankruptcy court has ordered A.J. Conner to pay the Company $23 million immediately upon consummation of a proposed merger with Garner Holding Group. Warranty expense ([2% x $2,100 million] – $1 million) 41,000,000 Estimated warranty liability 41,000,000 The liability at December 31, 2003, is reported as $41 million. 4. The Crump Holdings lawsuit is a loss contingency. Even though the lawsuit occurred in 2004, the cause for the action occurred in 2003. Only a disclosure note is needed because an unfavorable outcome is reasonably possible, but not probable. Also, the amount is not reasonably estimable. Crump Holdings filed suit in January 2004 against the Company seeking $88 million, as an adjustment to the purchase price in connection w ith the Company's sale of its textile business in 2003. Crump alleges that the Company misstated the purchase price for the division. The Compa ny has answered the complaint and intends to vigorously defend the lawsuit. Management belie ves that the final resolution of the case will not have a material adverse effect on the Company's financial position. 1. The five components of current liabilities are: Current portion of long-term debt $ 221,392 $ 6,537 Accrued salaries and employee benefits 699,906 755,747 Accounts payable 1,255,298 1,120,855 Accrued expenses 1,072,920 1,007,887 Total current liabilities 3,249,516 2,891,026 which is close to the same. Comparing liabilities that must be satisfied soon with