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Each question should be answered in a min of 100 words. Questions are marked with a number. Intermediate Accounting, Ch. 13 Gain and Loss Contingencies , Bryan Lichau , 1. Identify the criteria used to account for and disclose gain and loss contingencies. 2. Explain the accounting for different types of loss contingencies. Current Liabilities, Bryan Lichau , 1. Describe the nature, type, and valuation of current liabilities. Current Liabilities CHRISTINE MAJETTE, Bryan Lichau , 1. Is there a time factor in when a current liability is considered a current liability versus noncurrent? Intermediate Accounting, Ch. 14 Long-Term Debt, Bryan Lichau , 1. Describe the formal procedures associated with issuing long-term debt. 2. Explain the accounting for long-term notes payable. Wiley 1. How to Account for Premiums and Coupons. 2. How to Account for Long-Term Notes Payable Using the Fair Value Option. Reading Concept Summary Write a 260- to 350-word summary of this week's readings. Describe major concepts you learned. Explain how you can apply what you learned to your current or future workplace. https://fod-infobase-com.contentproxy.phoenix.edu/p_ViewVideo.aspx?xtid=93896&loid=370092
13 Current Liabilities and Contingencies LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Describe the nature, valuation, and reporting of current liabilities. 2 Explain the classification issues of short-term debt expected to be refinanced. 3 Explain the accounting for gain and loss contingencies. 4 Indicate how to present and analyze liabilities and contingencies. NOW YOU SEE IT, NOW YOU DON'T A look at the liabilities side of the balance sheet of the company Beru AG Corporation, dated March 31, 2003, shows how international standards have changed regarding the reporting of financial information. Here is how one liability was shown on this date: Anticipated losses arising from pending transactions 3,285,000 euros Do you believe a liability should be reported for such transactions? Anticipated losses means the losses have not yet occurred. Pending transactions means that the condition that might cause the loss has also not occurred. So where is the liability? To whom does the company owe something? Where is the obligation? German accounting rules in 2003 were permissive. They allowed companies to report liabilities for possible future events. In essence, the establishment of this general-purpose “liability” provides a buffer for Beru if losses do materialize. If you take a more skeptical view, you might say the accounting rules let Beru smooth its income by charging expenses in good years and reducing expenses in bad years. The story has a happy ending: European companies switched to International Financial Reporting Standards (IFRS) in 2005. Under IFRS, liabilities like “Anticipated losses arising from pending transactions” disappear. So when we look at Beru's 2005 financial statements, we find a note stating that the company has reported as liabilities only obligations arising from past transactions that can be reasonably estimated. Standard-setters continue to work on the financial reporting of certain “contingent” liabilities, such as those related to pending lawsuits and other possible losses for which a company might be liable. As you will learn in this chapter, standard-setters have provided much more transparency in reporting liability-type transactions. However, much still needs to be done. For example, the IASB is considering major changes in how to recognize and measure contingent liabilities. The task will not be easy. Consider a simple illustration involving a company that sells hamburgers: • • • The hamburgers are sold in a jurisdiction where the law states that the seller must pay $100,000 to each customer that purchases a contaminated hamburger; At the end of the reporting period, the company has sold one hamburger; and Past experience indicates there is a one in a million chance that a hamburger sold by the entity is contaminated. No other information is available. Does the company have a liability? What is the conceptual justification, if any, to record a liability or for that matter, not to record a liability? And if you conclude that the sale of the hamburger results in a liability, how do you measure it? Another way to ask the question is whether the hamburger issue is a recognition issue or a measurement issue. This example illustrates some of the difficult questions that the IASB faces in this area. The FASB recently proposed expanded disclosure about the nature of contingencies, more quantitative and qualitative background on contingencies, and, maybe most welcome of all, required tabular presentation of the changes in contingencies, including explanation of the changes. Note that these disclosures are similar to those required in IFRS. What's not to like about these enhanced disclosures? Well quite a bit, according to responses by some companies and the legal profession. These parties are concerned that the information in these enhanced disclosures could be used against them in a lawsuit. These issues were in play in the recent product liability cases at Beazer Homes and Fiat Chrysler, and explains the strong opposition to the proposed rules. We do not know the end of this liability story. However, the controversy over the proposed rules illustrates the challenges of developing accounting rules for liabilities that meet the needs of investors while avoiding harm to the companies reporting the information. Sources: C. Rogers and M. Spector, “Fiat Chrysler Faces More Legal Hazards: Jeep Verdict Could Encourage Harder Lines Among Victims in Other Rear-End Crashes,” Wall Street Journal (April 6, 2015); and C. Dulaney, “Beazer Homes Loss Widens Amid Warranty Charge,” Wall Street Journal (January 31, 2015). REVIEW AND PRACTICE Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary review and practice problem with solution. Multiple-choice questions with annotated solutions as well as additional exercises and practice problem with solutions are also available online. CURRENT LIABILITIES LEARNING OBJECTIVE 1 Describe the nature, valuation, and reporting of current liabilities. The question, “What is a liability?” is not easy to answer. For example, is preferred stock a liability or an ownership claim? The first reaction is to say that preferred stock is in fact an ownership claim, and companies should report it as part of stockholders' equity. In fact, preferred stock has many elements of debt as well.1 The issuer (and in some cases the holder) often has the right to call the stock within a specific period of time—making it similar to a repayment of principal. The dividend on the preferred stock is in many cases almost guaranteed (the cumulative provision)—making it look like interest. As a result, preferred stock is one of many financial instruments that are difficult to classify.2 To help resolve some of these controversies, the FASB, as part of its conceptual framework, defined liabilities as “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.”3 In other words, a liability has three essential characteristics: 1. It is a present obligation that entails settlement by probable future transfer or use of cash, goods, or services. 2. It is an unavoidable obligation. 3. The transaction or other event creating the obligation has already occurred. UNDERLYING CONCEPTS To determine the appropriate classification of specific financial instruments, companies need proper definitions of assets, liabilities, and equities. They often use the conceptual framework definitions as the basis for resolving controversial classification issues. Because liabilities involve future disbursements of assets or services, one of their most important features is the date on which they are payable. A company must satisfy currently maturing obligations in the ordinary course of business to continue operating. Liabilities with a more distant due date do not, as a rule, represent a claim on the company's current resources. They are therefore in a slightly different category. This feature gives rise to the basic division of liabilities into (1) current liabilities and (2) long-term debt. Recall that current assets are cash or other assets that companies reasonably expect to convert into cash, sell, or consume in operations within a single operating cycle or within a year (if completing more than one cycle each year). 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.” [2] This definition has gained wide acceptance because it recognizes operating cycles of varying lengths in different industries. This definition also considers the important relationship between current assets and current liabilities. [3] The operating cycle is the period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final cash realization resulting from sales and subsequent collections. Industries that manufacture products requiring an aging process, and certain capital-intensive industries, have an operating cycle of considerably more than one year. On the other hand, most retail and service establishments have several operating cycles within a year. See the FASB Codification References (pages 708–709). Here are some typical current liabilities: 1. Accounts payable. 2. Notes payable. 3. Dividends payable. 4. Customer advances and deposits. 5. Unearned revenues. 6. Sales taxes payable. 7. Income taxes payable. 8. Employee-related liabilities. 9. Current maturities of long-term debt. 10. Short-term obligations expected to be refinanced. Accounts Payable Accounts payable, or trade accounts payable, are balances owed to others for goods, supplies, or services purchased on open account. Accounts payable arise because of the time lag between the receipt of services or acquisition of assets and the payment for them. The terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30 to 60 days. Most companies record liabilities for purchases of goods upon receipt of the goods. If control has passed to the purchaser before receipt of the goods, the purchaser should record the transaction at the time of transfer of control. A company must pay special attention to transactions occurring near the end of one accounting period and at the beginning of the next. It needs to ascertain that the record of goods received (the inventory) agrees with the liability (accounts payable), and that it records both in the proper period. Measuring the amount of an account payable poses no particular difficulty. The invoice received from the creditor specifies the due date and the exact outlay in money that is necessary to settle the account. The only calculation that may be necessary concerns the amount of cash discount. See Chapter 8 for illustrations of entries related to accounts payable and purchase discounts. Notes Payable Notes payable are written promises to pay a certain sum of money on a specified future date. They may arise from purchases, financing, or other transactions. Some industries require notes (often referred to as trade notes payable) as part of the sales/purchases transaction in lieu of the normal extension of open account credit. Notes payable to banks or loan companies generally arise from cash loans. Companies classify notes as short-term or long-term, depending on the payment due date. Notes may also be interest-bearing or zero-interest-bearing. Interest-Bearing Note Issued Assume that Castle National Bank agrees to lend $100,000 on March 1, 2017, to Landscape Co. if Landscape signs a $100,000, 6 percent, four-month note. Landscape records the cash received on March 1 as follows. March 1 Cash 100,000 Notes Payable 100,000 (To record issuance of 6%, 4-month note to Castle National Bank) If Landscape prepares financial statements semiannually, it makes the adjusting entry on page 662 to recognize interest expense and interest payable of $2,000 ($100,000×6%×4/12)$2,000 ($100,000×6%×4/12) at June 30. June 30 Interest Expense 2,000 Interest Payable 2,000 (To accrue interest for 4 months on Castle National Bank note) If Landscape prepares financial statements monthly, its adjusting entry at the end of each month is $500 ($100,000×6%×1/12)$500 ($100,000×6%×1/12). At maturity (July 1), Landscape must pay the face value of the note ($100,000) plus $2,000 interest ($100,000×6%×4/12)($100,000) plus $2,000 interest ($1 00,000×6%×4/12). Landscape records payment of the note and accrued interest as follows. July 1 Notes Payable Interest Payable Cash (To record payment of Castle National Bank interest-bearing note and accrued interest at maturity) 100,000 2,000 102,000 Zero-Interest-Bearing Note Issued A company may issue a zero-interest-bearing note instead of an interest-bearing note. A zerointerest-bearing note does not explicitly state an interest rate on the face of the note. Interest is still charged, however. At maturity, the borrower must pay back an amount greater than the cash received at the issuance date. In other words, the borrower receives in cash the present value of the note. The present value equals the face value of the note at maturity minus the interest or discount charged by the lender for the term of the note. In essence, the bank takes its fee “up front” rather than on the date the note matures. To illustrate, assume that Landscape issues a $102,000, four-month, zero-interest-bearing note to Castle National Bank. The present value of the note is $100,000.4 Landscape records this transaction as follows. March 1 Cash Discount on Notes Payable Notes Payable (To record issuance of 4-month, zero-interest-bearing note to Castle National Bank) 100,000 2,000 102,000 Landscape credits the Notes Payable account for the face value of the note, which is $2,000 more than the actual cash received. It debits the difference between the cash received and the face value of the note to Discount on Notes Payable. Discount on Notes Payable is a contra account to Notes Payable, and therefore is subtracted from Notes Payable on the balance sheet. Illustration 13-1 shows the balance sheet presentation on March 1. ILLUSTRATION 13-1 Balance Sheet Presentation of Discount Current liabilities Notes payable $102,000 Less: Discount on notes payable 2,000 $100,000 The amount of the discount, $2,000 in this case, represents the cost of borrowing $100,000 for 4 months. Accordingly, Landscape charges the discount to interest expense over the life of the note. That is, the Discount on Notes Payable balance represents interest expense chargeable to future periods. Thus, Landscape should not debit Interest Expense for $2,000 at the time of obtaining the loan. We discuss additional accounting issues related to notes payable in Chapter 14. Dividends Payable A cash dividend payable is an amount owed by a corporation to its stockholders as a result of its board of directors' authorization. At the date of declaration, the corporation assumes a liability that places the stockholders in the position of creditors in the amount of dividends declared. Because companies always pay cash dividends within one year of declaration (generally within three months), they classify them as current liabilities. On the other hand, companies do not recognize accumulated but undeclared dividends on cumulative preferred stock as a liability. Why? Because preferred dividends in arrears are not an obligation until the board of directors authorizes the payment. Nevertheless, companies should disclose the amount of cumulative dividends unpaid in a note, or show it parenthetically in the capital stock section. Dividends payable in the form of additional shares of stock are not recognized as a liability. Such stock dividends (as we discuss in Chapter 15) do not require future outlays of assets or services. Companies generally report such undistributed stock dividends in the stockholders' equity section because they represent retained earnings in the process of transfer to paid-in capital. UNDERLYING CONCEPTS Preferred dividends in arrears do represent a probable future economic sacrifice, but the expected sacrifice does not result from a past transaction or past event. The sacrifice will result from a future event (declaration by the board of directors). Note disclosure improves the predictive value of the financial statements. Customer Advances and Deposits Current liabilities may include returnable cash deposits received from customers and employees. Companies may receive deposits from customers to guarantee performance of a contract or service or as guarantees to cover payment of expected future obligations. For example, a company like Alltel Corp. often requires a deposit on equipment that customers use to connect to the Internet or to access its other services. Alltel also may receive deposits from customers as guarantees for possible damage to property. Additionally, some companies require their employees to make deposits for the return of keys or other company property. The classification of these items as current or noncurrent liabilities depends on the time between the date of the deposit and the termination of the relationship that required the deposit. Unearned Revenues A magazine publisher such as Condé Nast receives payment when a customer subscribes to Golf Digest. An airline company such as American Airlines sells tickets for future flights. And software companies like Microsoft issue coupons that allow customers to upgrade to the next version of their software. How do these companies account for unearned revenues that they receive before delivering goods or rendering services? 1. When a company receives an advance payment, it debits Cash, and credits a current liability account identifying the source of the unearned revenue. 2. When a company recognizes revenue, it debits the unearned revenue account, and credits a revenue account. To illustrate, assume that Allstate University sells 10,000 season football tickets at $50 each for its five-game home schedule. The entries for Allstate University's unearned ticket revenue are presented in Illustration 13-2 (page 664). ILLUSTRATION 13-2 Unearned Revenue Entries Allstate University records the sale of 10,000 season tickets on August 6: Cash 500,000 Unearned Sales Revenue (10,000 × $50) 500,000 When the first game is played on September 7, Allstate University records sales revenue: Unearned Sales Revenue (2,000 × $50) 100,000 Sales Revenue 100,000 As subsequent games are played, Allstate satisfies a performance obligation and records sales revenue (and reduces Unearned Sales Revenue). The account Unearned Sales Revenue represents unearned revenue. Allstate reports it as a current liability in the balance sheet as the school has a performance obligation. As the school recognizes revenue, it reclassifies the amount from Unearned Sales Revenue to Sales Revenue. Unearned revenue is material for some companies. In the airline industry, for example, tickets sold for future flights represent almost 50 percent of total current liabilities. Illustration 13-3 shows specific unearned revenue and revenue accounts used in selected types of businesses. Account Title Revenue Type of Business Unearned Revenue Unearned Ticket Revenue Passenger Revenue Airline Magazine publisher Unearned Subscription Revenue Subscription Revenue Hotel Unearned Rent Revenue Rent Revenue Auto dealer Unearned Warranty Revenue Warranty Revenue Retailers Unearned Gift Card Revenue Sales Revenue ILLUSTRATION 13-3 Unearned Revenue and Revenue Accounts The balance sheet reports obligations for any commitments that are redeemable in goods and services. The income statement reports revenues related to performance obligations satisfied during the period. WHAT DO THE NUMBERS MEAN? MICROSOFT'S LIABILITIES—GOOD OR BAD? Users of financial statements generally examine current liabilities to assess a company's liquidity and overall financial flexibility. Companies must pay many current liabilities, such as accounts payable, wages payable, and taxes payable, sooner rather than later. A substantial increase in these liabilities should raise a red flag about a company's financial position. This is not the case for all current liabilities. For example, Microsoft has a current liability entitled “Short-term unearned revenue” of $25,318 million in 2015 that has increased year after year. Unearned revenue is a liability that arises from sales of Microsoft products such as Internet Explorer and Windows. Microsoft also has provided coupons for upgrades to its programs to bolster sales of its XBox consoles and Surface tablets. At the time of a sale, customers pay not only for the current version of the product but also for future upgrades. Microsoft recognizes sales revenue from the current version of the software or product and records as a liability (unearned revenue) the value of future upgrades that it “owes” to customers. Market analysts read such an increase in unearned revenue as a positive signal about Microsoft's sales and profitability. When Microsoft's sales are growing, its unearned revenue account increases. Thus, an increase in a liability is good news about Microsoft sales. At the same time, a decline in unearned revenue is bad news. As one analyst noted, a slowdown or reversal of the growth in Microsoft's unearned revenues indicates slowing sales, which is bad news for investors. Thus, increases in current liabilities can sometimes be viewed as good signs instead of bad. Sources: Adapted from David Bank, “Some Fans Cool to Microsoft, Citing Drop in Old Indicator,” Wall Street Journal (October 28, 1999); Bloomberg News, “Microsoft Profit Hit by Deferred Sales; Forecast Raised,” The Globe and Mail (January 26, 2007), p. B8; and D. Bass, “Microsoft Unearned Revenue Tops Estimates on Upgrades,” Bloomberg Business (July 19, 2012). Sales Taxes Payable Retailers like Wal-Mart Stores, Inc., Best Buy Co., and Gap Inc. must collect sales taxes from customers on transfers of tangible personal property and on certain services and then must remit these taxes to the proper governmental authority. Gap, for example, sets up a liability to provide for taxes collected from customers but not yet remitted to the tax authority. The Sales Taxes Payable account should reflect the liability for sales taxes due various governments. The entry below illustrates use of the Sales Taxes Payable account on a sale of $3,000 when a 4 percent sales tax is in effect. Cash 3,120 Sales Revenue 3,000 Sales Taxes Payable 120 Sometimes the sales tax collections credited to the liability account are not equal to the liability as computed by the governmental formula. In such a case, Gap makes an adjustment of the liability account by recognizing a gain or a loss on sales tax collections. Many companies do not segregate the sales tax and the amount of the sale at the time of sale. Instead, the company credits both amounts in total in the Sales Revenue account. Then, to reflect correctly the actual amount of sales and the liability for sales taxes, the company would debit the Sales Revenue account for the amount of the sales taxes due the government on these sales, and would credit the Sales Taxes Payable account for the same amount. To illustrate, assume that the Sales Revenue account balance of $150,000$150,000 includes sales taxes of 4 percent. Thus, the amount recorded in the Sales Revenue account is comprised of the sales amount plus sales tax of 4 percent of the sales amount. Sales therefore are $144,230.77 ($150,000÷1.04)$144,230.77 ($150,000÷1.04) and the sales tax liability is $5,769.23 ($144,230.77×0.04$5,769.23 ($144,230.77×0.04; or $150,000−$144,230.77)$150,000−$144,230.77). The following entry would record the amount due the taxing unit. Sales Revenue 5,769.23 Sales Taxes Payable 5,769.23 Income Taxes Payable Any federal or state income tax varies in proportion to the amount of annual income. Using the best information and advice available, a business must prepare an income tax return and compute the income taxes payable resulting from the operations of the current period. Corporations should classify as a current liability the taxes payable on taxable income, as computed per the tax return.5 Unlike a corporation, proprietorships and partnerships are not taxable entities. Because the individual proprietor and the members of a partnership are subject to personal income taxes on their share of the business's taxable income, income tax liabilities do not appear on the financial statements of proprietorships and partnerships. Most corporations must make periodic tax payments throughout the year in an authorized bank depository or a Federal Reserve Bank. These payments are based upon estimates of the total annual tax liability. As the estimated total tax liability changes, the periodic contributions also change. If in a later year the taxing authority assesses an additional tax on the income of an earlier year, the company should credit Income Taxes Payable and charge the related debit to current operations. Differences between taxable income under the tax laws and accounting income under generally accepted accounting principles sometimes occur. Because of these differences, the amount of income taxes payable to the government in any given year may differ substantially from income tax expense as reported on the financial statements. Chapter 19 is devoted solely to income tax matters and presents an extensive discussion of this complex topic. Employee-Related Liabilities Companies also report as a current liability amounts owed to employees for salaries or wages at the end of an accounting period. In addition, they often also report as current liabilities the following items related to employee compensation. 1. Payroll deductions. 2. Compensated absences. 3. Bonuses. Payroll Deductions The most common types of payroll deductions are taxes, insurance premiums, employee savings, and union dues. To the extent that a company has not remitted the amounts deducted to the proper authority at the end of the accounting period, it should recognize them as current liabilities. Social Security Taxes. Since January 1, 1937, Social Security legislation has provided federal Old Age, Survivor, and Disability Insurance (OASDI) benefits for certain individuals and their families. Funds for these payments come from taxes levied on both the employer and the employee. Employers collect the employee's share of this tax by deducting it from the employee's gross pay, and remit it to the government along with their share. The government taxes both the employer and the employee at the same rate, currently 6.2 percent based on the employee's gross pay up to a $118,500 annual limit. The OASDI tax is usually referred to as FICA (the Federal Insurance Contribution Act). In 1965, Congress passed the first federal health insurance program for the aged—popularly known as Medicare. This two-part program alleviates the high cost of medical care for those over age 65. A separate Hospital Insurance tax, paid by both the employee and the employer at the rate of 1.45 percent on the employee's total compensation, finances the Basic Plan, which provides for hospital and other institutional services.6 The Voluntary Plan covers the major part of doctors' bills and other medical and health services. Monthly payments from all who enroll, plus matching funds from the federal government, finance this plan. The combination of the OASDI tax (FICA) and the federal Hospital Insurance Tax is commonly referred to as the Social Security tax. The combined rate for these taxes, 7.65 percent on an employee's wages to $118,500 and 1.45 percent in excess of $118,500, changes intermittently by acts of Congress. Companies should report the amount of unremitted employee and employer Social Security tax on gross wages paid as a current liability. Unemployment Taxes. Another payroll tax levied by the federal government in cooperation with state governments provides a system of unemployment insurance. All employers who meet the following criteria are subject to the Federal Unemployment Tax Act (FUTA): (1) those who paid wages of $1,500 or more during any calendar quarter in the year or preceding year, or (2) those who employed at least one individual on at least one day in each of 20 weeks during the current or preceding calendar year. In general, only employers pay the unemployment tax. The rate of this tax is 6.2 percent on the first $7,000 of compensation paid to each employee during the calendar year. The employer receives a tax credit not to exceed 5.4 percent for contributions paid to a state plan for unemployment compensation. Thus, if an employer is subject to a state unemployment tax of 5.4 percent or more, it pays only 0.8 percent tax to the federal government. State unemployment compensation laws differ both from the federal law and among various states. Therefore, employers must refer to the unemployment tax laws in each state in which they pay wages and salaries. The normal state tax may range from 3 percent to 7 percent or higher. However, all states provide for some form of merit rating, which reduces the state contribution rate. Employers who display by their benefit and contribution experience that they provide steady employment may receive this reduction—if the size of the state fund is adequate. In order not to penalize an employer who has earned a reduction in the state contribution rate, federal law allows a credit of 5.4 percent, even when the effective state contribution rate is less than 5.4 percent. To illustrate, Appliance Repair Co. has a taxable payroll of $100,000. It is subject to a federal rate of 6.2 percent and a state contribution rate of 5.7 percent. However, its stable employment experience reduces the company's state rate to 1 percent. Appliance Repair computes its federal and state unemployment taxes as shown in Illustration 13-4. State unemployment tax payment (1% × $100,000) $1,000 Federal unemployment tax [(6.2% − 5.4%) × $100,000] 600 Total federal and state unemployment tax $1,600 ILLUSTRATION 13-4 Computation of Unemployment Taxes Companies pay federal unemployment tax quarterly, and file a tax form annually. Companies also generally pay state contributions quarterly as well. Because both the federal and the state unemployment taxes accrue on earned compensation, companies should record the amount of accrued but unpaid employer contributions as an operating expense and as a current liability when preparing financial statements at year-end. Income Tax Withholding. Federal and some state income tax laws require employers to withhold from each employee's pay the applicable income tax due on those wages. The employer computes the amount of income tax to withhold according to a government-prescribed formula or withholding tax table. That amount depends on the length of the pay period and each employee's taxable wages, marital status, and claimed dependents. If the income tax withheld plus the employee and the employer Social Security taxes exceeds specified amounts per month, the employer must make remittances to the government during the month. Illustration 13-5 summarizes payroll deductions and liabilities. ILLUSTRATION 13-5 Summary of Payroll Liabilities Payroll Deductions Example. Assume a weekly payroll of $10,000 entirely subject to FICA and Medicare (7.65%), federal (0.8%) and state (4%) unemployment taxes, with income tax withholding of $1,320 and union dues of $88 deducted. Illustration 13-6 presents the entries for payroll and payroll deductions. To record salaries and wages paid and the employee payroll deductions: Salaries and Wages Expense 10,000 Withholding Taxes Payable 1,320 FICA Taxes Payable 765 Union Dues Payable 88 Cash 7,827 To record employer payroll taxes: Payroll Tax Expense 1,245 FICA Taxes Payable 765 FUTA Taxes Payable 80 SUTA Taxes Payable 400 ILLUSTRATION 13-6 Payroll Deductions The employer must remit to the government its share of FICA tax along with the amount of FICA tax deducted from each employee's gross compensation. It records all unremitted employer FICA taxes as payroll tax expense and payroll taxes payable.7 Compensated Absences Compensated absences are paid absences from employment—such as vacation, illness, and holidays.8 Companies should accrue a liability for the cost of compensation for future absences if all of the following conditions exist. [4] (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. [5] UNDERLYING CONCEPTS When these four conditions exist, all elements in the definition of a liability exist. In addition, the expense recognition principle requires that the company report the expense for the services in the period consumed. Illustration 13-7 shows an example of an accrual for compensated absences, in an excerpt from the balance sheet of Clarcor Inc. Clarcor Inc. Current liabilities Accounts payable $ 6,308 Accrued salaries, wages and commissions 2,278 Compensated absences 2,271 Accrued pension liabilities 1,023 Other accrued liabilities 4,572 $16,452 ILLUSTRATION 13-7 Balance Sheet Presentation of Accrual for Compensated Absences If an employer meets conditions (a), (b), and (c) but does not accrue a liability because of a failure to meet condition (d), it should disclose that fact. Illustration 13-8 shows an example of such a disclosure, in a note from the financial statements of Gotham Utility Company. Gotham Utility Company Employees of the Company are entitled to paid vacation, personal, and sick days off, depending on job status, length of service, and other factors. Due to numerous differing union contracts and other agreements with nonunion employees, it is impractical to estimate the amount of compensation for future absences, and, accordingly, no liability has been reported in the accompanying financial statements. The Company's policy is to recognize the cost of compensated absences when actually paid to employees; compensated absence payments to employees totaled $2,786,000. ILLUSTRATION 13-8 Disclosure of Policy for Compensated Absences The following considerations are relevant to the accounting for compensated absences. Vested rights exist when an employer has an obligation to make payment to an employee even after terminating his or her employment. Thus, vested rights are not contingent on an employee's future service. Accumulated rights are those that employees can carry forward to future periods if not used in the period in which earned. For example, assume that you earn four days of vacation pay as of December 31, the end of your employer's fiscal year. Company policy is that you will be paid for this vacation time even if you terminate employment. In this situation, your four days of vacation pay are vested, and your employer must accrue the amount. Now assume that your vacation days are not vested but that you can carry the four days over into later periods. Although the rights are not vested, they are accumulated rights for which the employer must make an accrual. However, the amount of the accrual is adjusted to allow for estimated forfeitures due to turnover. A modification of the general rules relates to the issue of sick pay. If sick pay benefits vest, a company must accrue them. If sick pay benefits accumulate but do not vest, a company may choose whether to accrue them. Why this distinction? Companies may administer compensation designated as sick pay in one of two ways. In some companies, employees receive sick pay only if illness causes their absence. Therefore, these companies may or may not accrue a liability because its payment depends on future employee illness. Other companies allow employees to accumulate unused sick pay and take compensated time off from work even when not ill. For this type of sick pay, a company must accrue a liability because the company will pay it, regardless of whether employees become ill. Companies should recognize the expense and related liability for compensated absences in the year earned by employees. For example, if new employees receive rights to two weeks' paid vacation at the beginning of their second year of employment, a company considers the vacation pay to be earned during the first year of employment. What rate should a company use to accrue the compensated absence cost—the current rate or an estimated future rate? GAAP is silent on this subject. Therefore, companies will likely use the current rather than future rate. The future rate is less certain and raises time value of money issues. To illustrate, assume that Amutron Inc. began operations on January 1, 2017. The company employs 10 individuals and pays each $480 per week. Employees earned 20 unused vacation weeks in 2017. In 2018, the employees used the vacation weeks, but now they each earn $540 per week. Amutron accrues the accumulated vacation pay on December 31, 2017, as follows. Salaries and Wages Expense 9,600 Salaries and Wages Payable ($480 × 20) 9,600 At December 31, 2017, the company reports on its balance sheet a liability of $9,600. In 2018, it records the payment of vacation pay as follows. Salaries and Wages Payable 9,600 Salaries and Wages Expense 1,200 Cash ($540 × 20) 10,800 In 2018, the use of the vacation weeks extinguishes the liability. Note that Amutron records the difference between the amount of cash paid and the reduction in the liability account as an adjustment to Salaries and Wages Expense in the period when paid. This difference arises because it accrues the liability account at the rates of pay in effect during the period when employees earned the compensated time. The cash paid, however, depends on the rates in effect during the period when employees used the compensated time. If Amutron used the future rates of pay to compute the accrual in 2017, then the cash paid in 2018 would equal the liability.9 Bonus Agreements Many companies give a bonus to certain or all employees in addition to their regular salaries or wages. Frequently the bonus amount depends on the company's yearly profit. For example, employees at Ford Motor Company share in the success of the company's operations on the basis of a complicated formula using net income as its primary basis for computation. A company may consider bonus payments to employees as additional wages and should include them as a deduction in determining the net income for the year. To illustrate the entries for an employee bonus, assume that Palmer Inc. shows income for the year 2017 of $100,000. It will pay out bonuses of $10,700 in January 2018. Palmer makes the entries presented in Illustration 13-9. Adjusting entry dated December 31, 2017, to record the bonuses: Salaries and Wages Expense 10,700 Salaries and Wages Payable 10,700 Bonus paid in January 2018: Salaries and Wages Payable 10,700 Cash 10,700 ILLUSTRATION 13-9 Bonus Plan Entries Palmer should show the expense account in the income statement as an operating expense. The liability, Salaries and Wages Payable, is usually payable within a short period of time. Companies should include it as a current liability in the balance sheet. Similar to bonus agreements are contractual agreements for conditional expenses. Examples would be agreements covering rents or royalty payments conditional on the amount of revenues recognized or the quantity of product produced or extracted. Conditional expenses based on revenues or units produced are usually less difficult to compute than bonus arrangements. For example, assume that a lease calls for a fixed rent payment of $500 per month and 1 percent of all sales over $300,000 per year. The company's annual rent obligation would amount to $6,000 plus $0.01 of each dollar of revenue over $300,000. Or, a royalty agreement may give to a patent owner $1 for every ton of product resulting from the patented process, or give to a mineral rights owner $0.50 on every barrel of oil extracted. As the company produces or extracts each additional unit of product, it creates an additional obligation, usually a current liability. Current Maturities of Long-Term Debt PepsiCo reports as part of its current liabilities the portion of bonds, mortgage notes, and other long-term indebtedness that matures within the next fiscal year. It categorizes this amount as current maturities of long-term debt. Companies, like PepsiCo, exclude long-term debts maturing currently as current liabilities if they are to be: 1. Retired by assets accumulated for this purpose that properly have not been shown as current assets, 2. Refinanced, or retired from the proceeds of a new debt issue, or 3. Converted into capital stock. In these situations, the use of current assets or the creation of other current liabilities does not occur. Therefore, classification as a current liability is inappropriate. A company should disclose the plan for liquidation of such a debt either parenthetically or by a note to the financial statements. When only a part of a long-term debt is to be paid within the next 12 months, as in the case of serial bonds that it retires through a series of annual installments, the company reports the maturing portion of long-term debt as a current liability, and the remaining portion as a long-term debt. However, a company should classify as current any liability that is due on demand (callable by the creditor) or will be due on demand within a year (or operating cycle, if longer). Liabilities often become callable by the creditor when there is a violation of the debt agreement. For example, most debt agreements specify a given level of equity to debt be maintained, or specify that working capital be of a minimum amount. If the company violates an agreement, it must classify the debt as current because it is a reasonable expectation that existing working capital will be used to satisfy the debt. Only if a company can show that it is probable that it will cure (satisfy) the violation within the grace period specified in the agreements can it classify the debt as noncurrent. [6] Short-Term Obligations Expected to Be Refinanced LEARNING OBJECTIVE 2 Explain the classification issues of short-term debt expected to be refinanced. Short-term obligations are debts scheduled to mature within one year after the date of a company's balance sheet or within its operating cycle, whichever is longer. Some short-term obligations are expected to be refinanced on a long-term basis. These short-term obligations will not require the use of working capital during the next year (or operating cycle, if longer).10 At one time, the accounting profession generally supported the exclusion of short-term obligations from current liabilities if they were “expected to be refinanced.” But the profession provided no specific guidelines, so companies determined whether a short-term obligation was “expected to be refinanced” based solely on management's intent to refinance on a long-term basis. Classification was not clear-cut. For example, a company might obtain a five-year bank loan but handle the actual financing with 90-day notes, which it must keep turning over (renewing). In this case, is the loan a long-term debt or a current liability? Another example was the Penn Central Railroad before it went bankrupt. The railroad was deep into short-term debt but classified it as long-term debt. Why? Because the railroad believed it had commitments from lenders to keep refinancing the short-term debt. When those commitments suddenly disappeared, it was “good-bye Pennsy.” As the Greek philosopher Epictetus once said, “Some things in this world are not and yet appear to be.” Refinancing Criteria To resolve these classification problems, the accounting profession has developed criteria for determining the circumstances under which short-term obligations may be properly excluded from current liabilities. A company is required to exclude a short-term obligation from current liabilities if both of the following conditions are met: 1. It must intend to refinance the obligation on a long-term basis. 2. It must demonstrate an ability to consummate the refinancing. [7]11 Intention to refinance on a long-term basis means that the company intends to refinance the short-term obligation so that it will not require the use of working capital during the ensuing fiscal year (or operating cycle, if longer). The company demonstrates the ability to consummate the refinancing by: (a)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 (b) 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. If an actual refinancing occurs, the portion of the short-term obligation to be excluded from current liabilities may not exceed the proceeds from the new obligation or equity securities used to retire the short-term obligation. For example, Montavon Winery had $3,000,000 of shortterm debt. Subsequent to the balance sheet date but before issuing the balance sheet, the company issued 100,000 shares of common stock, intending to use the proceeds to liquidate the short-term debt at its maturity. If Montavon's net proceeds from the sale of the 100,000 shares total $2,000,000, it can exclude from current liabilities only $2,000,000 of the short-term debt. INTERNATIONAL PERSPECTIVE IFRS requires that the current portion of long-term debt be classified as current unless an agreement to refinance on a long-term basis is completed before the date of the financial statements. An additional question is whether a company should exclude from current liabilities a short-term obligation if it is paid off after the balance sheet date and replaced by long-term debt before the balance sheet is issued. To illustrate, Marquardt Company pays off short-term debt of $40,000 on January 17, 2018, and issues long-term debt of $100,000 on February 3, 2018. Marquardt's financial statements, dated December 31, 2017, are to be issued March 1, 2018. Should Marquardt exclude the $40,000 short-term debt from current liabilities? No—here's why: Repayment of the short-term obligation required the use of existing current assets before the company obtained funds through long-term financing. Therefore, Marquardt must include the short-term obligations in current liabilities at the balance sheet date (as shown in Illustration 1310). ILLUSTRATION 13-10 Short-Term Debt Paid Off after Balance Sheet Date and Later Replaced by Long-Term Debt WHAT DO THE NUMBERS MEAN? WHAT ABOUT THAT SHORT-TERM DEBT? The evaluation of credit quality involves more than simply assessing a company's ability to repay loans. Credit analysts also evaluate debt management strategies. Analysts and investors will reward what they view as prudent management decisions with lower debt service costs and a higher stock price. The wrong decisions can bring higher debt costs and lower stock prices. General Electric Capital Corp., a subsidiary of General Electric, experienced the negative effects of market scrutiny of its debt management policies. Analysts complained that GE had been slow to refinance its mountains of short-term debt. GE had issued these current obligations, with maturities of 270 days or less, when interest rates were low. However, in light of expectations that the Fed would raise interest rates, analysts began to worry about the higher interest costs GE would pay when it refinanced these loans. Some analysts recommended that it was time to reduce dependence on short-term credit. The reasoning goes that a shift to more dependable long-term debt, thereby locking in slightly higher rates for the long-term, is the better way to go. Thus, scrutiny of GE debt strategies led to analysts' concerns about GE's earnings prospects. Investors took the analysis to heart, and GE experienced a two-day 6 percent drop in its stock price. Recently, GE and other companies, such as UPS and Apple, have responded to these criticisms and have been increasing issuance of long-term debt to lock-in continuing low interest rates. Sources: Adapted from Steven Vames, “Credit Quality, Stock Investing Seem to Go Hand in Hand,” Wall Street Journal (April 1, 2002), p. R4; V. Monga, “Companies Feast on Cheap Money Market for 30-Year Bonds, Priced at Stark Lows, Brings Out GE, UPS and Other OnceShy Issuers,” Wall Street Journal (October 8, 2012); and K. Burne and M. Cheney, “Apple's Record Plunge into the Debt Pool,” Wall Street Journal (May, 1, 2013). CONTINGENCIES LEARNING OBJECTIVE 3 Explain the accounting for gain and loss contingencies. Companies often are involved in situations where uncertainty exists about whether an obligation to transfer cash or other assets has arisen and/or the amount that will be required to settle the obligation. For example: • • • Merck may be a defendant in a lawsuit, and any payment is contingent upon the outcome of a settlement or an administrative or court proceeding. Ford Motor Company provides a warranty for a car it sells, and any payments are contingent on the number of cars that qualify for benefits under the warranty. Briggs & Stratton acts as a guarantor on a loan for another entity, and any payment is contingent on whether the other entity defaults. Broadly, these situations are called contingencies. A contingency is “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.” [8] Gain Contingencies Gain contingencies are claims or rights to receive assets (or have a liability reduced) whose existence is uncertain but which may become valid eventually. The typical gain contingencies are: 1. Possible receipts of monies from gifts, donations, asset sales, and so on. 2. Possible refunds from the government in tax disputes. 3. Pending court cases with a probable favorable outcome. 4. Tax loss carryforwards (discussed in Chapter 19).12 Companies follow a conservative policy in this area; they do not record gain contingencies. A company discloses gain contingencies in the notes only when a high probability exists for realizing them. As a result, it is unusual to find information about contingent gains in the financial statements and the accompanying notes. Illustration 13-11 (page 674) presents an example of a gain contingency disclosure. BMC Industries, Inc. Note 13: Legal Matters. In the first quarter, a U.S. District Court in Miami, Florida, awarded the Company a $5.1 million judgment against Barth Industries (Barth) of Cleveland, Ohio and its parent, Nesco Holdings, Inc. (Nesco). The judgment relates to an agreement under which Barth and Nesco were to help automate the plastic lens production plant in Fort Lauderdale, Florida. The Company has not recorded any income relating to this judgment because Barth and Nesco have filed an appeal. ILLUSTRATION 13-11 Disclosure of Gain Contingency Loss Contingencies Loss contingencies involve possible losses. A liability incurred as a result of a loss contingency is by definition a contingent liability. Contingent liabilities depend on the occurrence of one or more future events to confirm either the amount payable, the payee, the date payable, or its existence. That is, these factors depend on a contingency. Likelihood of Loss When a loss contingency exists, the likelihood that the future event or events will confirm the incurrence of a liability can range from probable to remote. The FASB uses the terms probable, reasonably possible, and remote to identify three areas within that range and assigns the following meanings. INTERNATIONAL PERSPECTIVE IFRS uses the term provisions to refer to estimated liabilities. • • • Probable. The future event or events are likely to occur. Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely. Remote. The chance of the future event or events occurring is slight. Companies should accrue an estimated loss from a loss contingency by a charge to expense and a liability recorded only if both of the following conditions are met.13 1. 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. 2. The amount of the loss can be reasonably estimated. To record a liability, a company does not need to know the exact payee nor the exact date payable. What a company must know is whether it is probable that it incurred a liability. To meet the second criterion, a company needs to be able to reasonably determine an amount for the liability. To determine a reasonable estimate of the liability, a company may use its own experience, experience of other companies in the industry, engineering or research studies, legal advice, or educated guesses by qualified personnel. Illustration 13-12 shows disclosure of an accrual recorded for a loss contingency, from the annual report of Quaker State Oil Refining Company. Quaker State Oil Refining Company Note 5: Contingencies. During the period from November 13 to December 23, a change in an additive component purchased from one of its suppliers caused certain oil refined and shipped to fail to meet the Company's low-temperature performance requirements. The Company has recalled this product and has arranged for reimbursement to its customers and the ultimate consumers of all costs associated with the product. Estimated cost of the recall program, net of estimated third party reimbursement, in the amount of $3,500,000 has been charged to current operations. ILLUSTRATION 13-12 Disclosure of Accrual for Loss Contingency Use of the terms probable, reasonably possible, and remote to classify contingencies involves judgment and subjectivity. Illustration 13-13 lists examples of loss contingencies and the general accounting treatment accorded them. Usually Accrued Loss Related to: 1. Collectibility of receivables 2. Obligations related to product warranties and product defects 3. Premiums offered to customers Not Accrued Loss Related to: 4. Risk of loss or damage of enterprise property by fire, explosion, or other hazards 5. General or unspecified business risks 6. Risk of loss from catastrophes assumed by property and casualty insurance companies, including reinsurance companies May Be Accrued* Loss Related to: 7. Threat of expropriation of assets 8. Pending or threatened litigation 9. Actual or possible claims and assessments** 10. Guarantees of indebtedness of others 11. Obligations of commercial banks under “standby letters of credit” 12. Agreements to repurchase receivables (or the related property) that have been sold *Should be accrued when both criteria—probable and reasonably estimable—are met. **Estimated amounts of losses incurred prior to the balance sheet date but settled subsequently should be accrued as of the balance sheet date. ILLUSTRATION 13-13 Accounting Treatment of Loss Contingencies Practicing accountants express concern over the diversity that now exists in the interpretation of “probable,” “reasonably possible,” and “remote.” Current practice relies heavily on the exact language used in responses received from lawyers (such language is necessarily biased and protective rather than predictive). As a result, accruals and disclosures of contingencies vary considerably in practice. Some of the more common loss contingencies are:14 1. Litigation, claims, and assessments. 2. Guarantee and warranty costs. 3. Consideration payable (e.g., premiums and coupons). 4. Environmental liabilities. As discussed in the opening story, companies do not record or report in the notes to the financial statements general risk contingencies inherent in business operations (e.g., the possibility of war, strike, uninsurable catastrophes, or a business recession). Litigation, Claims, and Assessments Companies must consider the following factors, among others, in determining whether to record a liability with respect to pending or threatened litigation and actual or possible claims and assessments. 1. The time period in which the underlying cause of action occurred. 2. The probability of an unfavorable outcome. 3. The ability to make a reasonable estimate of the amount of loss. To report a loss and a liability in the financial statements, the cause for litigation must have occurred on or before the date of the financial statements. It does not matter that the company became aware of the existence or possibility of the lawsuit or claims after the date of the financial statements but before issuing them. To evaluate the probability of an unfavorable outcome, a company considers the following: the nature of the litigation, the progress of the case, the opinion of legal counsel, its own and others' experience in similar cases, and any management response to the lawsuit. Companies can seldom predict the outcome of pending litigation, however, with any assurance. And, even if evidence available at the balance sheet date does not favor the company, it is hardly reasonable to expect the company to publish in its financial statements a dollar estimate of the probable negative outcome. Such specific disclosures might weaken the company's position in the dispute and encourage the plaintiff to intensify its efforts. A typical example of the wording of such a disclosure is the note to the financial statements of Apple Inc., relating to its litigation concerning repetitive stress injuries, as shown in Illustration 13-14. Apple Inc. “Repetitive Stress Injury” Litigation. The Company is named in numerous lawsuits (fewer than 100) alleging that the plaintiff incurred so-called “repetitive stress injury” to the upper extremities as a result of using keyboards and/or mouse input devices sold by the Company. In a trial of one of these cases (Dorsey v. Apple) in the United States District Court for the Eastern District of New York, the jury rendered a verdict in favor of the Company, and final judgment in favor of the Company has been entered. The other cases are in various stages of pretrial activity. These suits are similar to those filed against other major suppliers of personal computers. Ultimate resolution of the litigation against the Company may depend on progress in resolving this type of litigation in the industry overall. ILLUSTRATION 13-14 Disclosure of Litigation With respect to unfiled suits and unasserted claims and assessments, a company must determine (1) the degree of probability that a suit may be filed or a claim or assessment may be asserted, and (2) the probability of an unfavorable outcome. For example, assume that the Federal Trade Commission investigates the Nawtee Company for restraint of trade, and institutes enforcement proceedings. Private claims of triple damages for redress often follow such proceedings. In this case, Nawtee must determine the probability of the claims being asserted and the probability of triple damages being awarded. If both are probable, if the loss is reasonably estimable, and if the cause for action is dated on or before the date of the financial statements, then Nawtee should accrue the liability.15 Guarantee and Warranty Costs A warranty (product guarantee) is a promise made by a seller to a buyer to make good on a deficiency of quantity, quality, or performance in a product. Manufacturers commonly use it as a sales promotion technique. Automakers, for instance, “hyped” their sales by extending their newcar warranty to seven years or 100,000 miles. For a specified period of time following the date of sale to the consumer, the manufacturer may promise to bear all or part of the cost of replacing defective parts, to perform any necessary repairs or servicing without charge, to refund the purchase price, or even to “double your money back.” Warranties and guarantees entail future costs. These additional costs, sometimes called “after costs” or “post-sale costs,” frequently are significant. Although the future cost is indefinite as to amount, due date, and even customer, the company has a performance obligation for which a liability should be recognized. The estimated amount of the liability includes all the costs that the company will incur after sale and delivery and that are incident to the correction of defects or deficiencies required under the warranty provisions. Warranty costs are a classic example of a loss contingency. Companies often provide one of two types of warranties to customers: 1. Warranty that the product meets agreed-upon specifications in the contract at the time the product is sold. This type of warranty is included in the sales price of a company's product and is often referred to as an assurance-type warranty. 2. Warranty that provides an additional service beyond the assurance-type warranty. This warranty is not included in the sales price of the product and is referred to as a service-type warranty. As a result, it is recorded as a separate performance obligation. Assurance-Type Warranty. Companies do not record a separate performance obligation for assurance-type warranties. This type of warranty is nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These types of obligations should be expensed in the period the goods are provided or services performed. In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur in the future due to the correction of defects or deficiencies required under the warranty provisions. Illustration 13-15 provides an example of an assurance-type warranty. ILLUSTRATION 13-15 Accounting for an Assurance-Type Warranty ASSURANCE-TYPE WARRANTY Facts: Denson Machinery Company begins production of a new machine in July 2017 and sells 100 of these machines for $5,000 cash by year-end for a total sales revenue of $500,000 (100 × $5,000). Each machine is under warranty for one year. Denson estimates, based on past experience with similar machines, that the warranty cost will average $200 per unit for a total expected warranty expense of $20,000 (100 × $200). Further, as a result of parts replacements and services performed in compliance with machinery warranties, it incurs $4,000 in warranty costs in 2017 and $16,000 in 2018. Question: What are the journal entries for the sale and the related warranty costs for 2017 and 2018? Solution: For the sale of the machines and related warranty costs in 2017, the entries are as follows. 1. To recognize sales of machines: July–December 2017 Cash 500,000 Sales Revenue 500,000 2. To record payment for warranty costs incurred in 2017: July–December 2017 Warranty Expense 4,000 Cash, Inventory, Accrued Payroll 4,000 3. The adjusting entry to record estimated warranty expense and warranty liability for expected warranty claims in 2018: December 31, 2017 Warranty Expense 16,000 Warranty Liability 16,000 As a consequence of this adjusting entry at December 31, 2017, the balance sheet reports a warranty liability (current) of $16,000 ($20,000 − $4,000). The income statement for 2017 reports sales revenue of $500,000 and warranty expense of $20,000. 4. To record payment for warranty costs incurred in 2018 related to 2017 machinery sales: January 1–December 31, 2018 Warranty Liability 16,000 Cash, Inventory, Accrued Payroll 16,000 At the end of 2018, no warranty liability is reported for the machinery sold in 2017. Service-Type Warranty. A warranty is sometimes sold separately from the product. For example, when you purchase a television, you are entitled to an assurance-type warranty. You also will undoubtedly be offered an extended warranty on the product at an additional cost, referred to as a service-type warranty. In most cases, service-type warranties provide the customer a service beyond fixing defects that existed at the time of sale. Companies record a service-type warranty as a separate performance obligation. For example, in the case of the television, the seller recognizes the sale of the television with the assurance-type warranty separately from the sale of the service-type warranty. The sale of the service-type warranty is usually recorded in an Unearned Warranty Revenue account. Companies then recognize revenue on a straight-line basis over the period the service-type warranty is in effect. Companies only defer and amortize costs that vary with and are directly related to the sale of the contracts (mainly commissions). Companies expense employees' salaries and wages, advertising, and general and administrative expenses because these costs occur even if the company did not sell the service-type warranty. Illustration 13-16 presents an example of both an assurance-type and service-type warranty. ILLUSTRATION 13-16 Assurance-Type and Service-Type Warranties WARRANTIES Facts: You purchase an automobile from Hamlin Auto for $30,000 on January 2, 2017. Hamlin estimates the assurance-type warranty costs on the automobile to be $700 (Hamlin will pay for repairs for the first 36,000 miles or three years, whichever comes first). You also purchase for $900 a service-type warranty for an additional three years or 36,000 miles. Hamlin incurs warranty costs related to the assurance-type warranty of $500 in 2017 and $200 in 2018. Hamlin records revenue on the service-type warranty on a straight-line basis. Question: What entries should Hamlin make in 2017 and 2020? Solution: 1. To record the sale of the automobile and related warranties: January 2, 2017 Cash ($30,000 + $900) 30,900 Unearned Warranty Revenue 900 Sales Revenue 30,000 2. To record warranty costs incurred in 2017: January 2–December 31 2017 Warranty Expense 500 Cash, Inventory, Accrued Payroll 500 3. The adjusting entry to record estimated warranty expense and warranty liability for expected assurance warranty claims in 2018: December 31, 2017 Warranty Expense 200 Warranty Liability 200 As a consequence of this adjusting entry at December 31, 2017, the balance sheet reports a warranty liability of $200 ($700 − $500) for the assurance-type warranty. The income statement for 2017 reports sales revenue of $30,000 and warranty expense of $700. 4. To record revenue recognized in 2020 on the service-type warranty: January 1–December 31, 2020 Unearned Warranty Revenue ($900 ÷ 3) 300 Warranty Revenue 300 Warranty costs under the service-type warranty will be expensed as incurred in 2020–2022. UNDERLYING CONCEPTS Warranties and coupons are loss contingencies that satisfy the conditions necessary for a liability. Regarding the income statement, the expense recognition principle requires that companies report the related expense in the period in which the sale occurs. Consideration Payable Companies often make payments (provide consideration) to their customers as part of a revenue arrangement. Consideration paid or payable may indicate discounts, volume rebates, free products, or services. For example, numerous companies offer premiums (either on a limited or continuing basis) to customers in return for box tops, certificates, coupons, labels, or wrappers. The premium may be silverware, dishes, a small appliance, a toy, or free transportation. Also, printed coupons that can be redeemed for a cash discount on items purchased are extremely popular. Another popular marketing innovation is the cash rebate, which the buyer can obtain by returning the store receipt, a rebate coupon, and Universal Product Code (UPC label) or “bar code” to the manufacturer.16 Companies offer premiums, coupon offers, and rebates to stimulate sales. And to the extent that the premiums reflect a material right promised to the customer, a performance obligation exists and should be recorded as a liability. However, the period that benefits is not necessarily the period in which the company pays the premium. At the end of the accounting period, many premium offers may be outstanding and must be redeemed when presented in subsequent periods. In order to reflect the existing current liability, the company estimates the number of outstanding premium offers that customers will present for redemption. The company then charges the cost of premium offers to Premium Expense. It credits the outstanding obligations to an account titled Premium Liability. [9] Illustration 13-17 provides an example of the accounting for consideration payable using premiums.17 ILLUSTRATION 13-17 Accounting for Consideration Payable CONSIDERATION PAYABLE Facts: Fluffy Cake Mix Company sells boxes of cake mix for $3 per box. In addition, Fluffy Cake Mix offers its customers a large durable mixing bowl in exchange for $1 and 10 box tops. The mixing bowl costs Fluffy Cake Mix $2, and the company estimates that customers will redeem 60 percent of the box tops. The premium offer began in June 2017. During 2017, Fluffy Cake Mix purchased 20,000 mixing bowls at $2, sold 300,000 boxes of cake mix for $3 per box, and redeemed 60,000 box tops. Question: What entries should Fluffy Cake Mix record in 2017? Solution: 1. To record purchase of 20,000 mixing bowls at $2 per bowl in 2017: Inventory of Premiums (20,000 mixing bowls × $2) 40,000 Cash 40,000 2. The entry to record the sale of the cake mix boxes in 2017 is as follows: Cash (300,000 boxes of cake mix × $3) 900,000 Sales Revenue 900,000 3. To record the actual redemption of 60,000 box tops, the receipt of $1 per 10 box tops, and the delivery of the mixing bowls: Cash [(60,000 ÷ 10) × $1] Premium Expense 6,000 6,000 Inventory of Premiums [(60,000 ÷ 10) × $2] 12,000 4. The adjusting entry to record additional premium expense and the estimated premium liability at December 31, 2017, is as follows: Premium Expense 12,000 Premium Liability 12,000* *Computation of Premium Liability at 12/31/17: Total box tops sold in 2017 300,000 Estimated redemptions (in percent) 60% Total estimated redemptions 180,000 Cost of estimated redemptions [(180,000 box tops ÷ 10) × ($2 − $1)] $18,000 Redemptions to date (6,000) Liability at 12/31/17 $12,000 The December 31, 2017, balance sheet of Fluffy Cake Mix reports Premium inventory of $28,000 ($40,000−$12,000)$28,000 ($40,000−$12,000) as a current asset and Premium Liability of $12,000 ($18,000−$6,000)$12,000 ($18,000−$6,000) as a current liability. The 2017 income statement reports $18,000 premium expense as a selling expense. WHAT DO THE NUMBERS MEAN? FREQUENT FLYERS Numerous companies offer premiums to customers in the form of a promise of future goods or services as an incentive for purchases today. Premium plans that have widespread adoption are the frequent-flyer programs used by all major airlines. On the basis of mileage accumulated, frequent-flyer members receive discounted or free airline tickets. Airline customers can earn miles toward free travel by making expenditures for such items as staying in hotels and charging gasoline and groceries on a credit card. Those free tickets represent an enormous potential liability because people using them may displace paying passengers. When airlines first started offering frequent-flyer bonuses, everyone assumed that they could accommodate the free-ticket holders with otherwise-empty seats. That made the additional cost of the program so minimal that airlines didn't accrue it or report the small liability. But, as more and more paying passengers have been crowded off flights by frequent-flyer awardees, the loss of revenues has grown enormously. For example, Delta Air Lines reported liabilities of over $4.2 billion for frequent-flyer tickets. Environmental Liabilities Estimates to clean up existing toxic waste sites total upward of $752 billion over a 30-year period. In addition, cost estimates of cleaning up our air and preventing future deterioration of the environment run even higher. These costs are likely to only grow, considering “Superfund legislation.” This federal legislation provides the Environmental Protection Agency (EPA) with the power to clean up waste sites and charge the clean-up costs to parties the EPA deems responsible for contaminating the site. These potentially responsible parties can have a significant liability. In many industries, the construction and operation of long-lived assets involves obligations for the retirement of those assets. When a mining company opens up a strip mine, it may also commit to restore the land once it completes mining. Similarly, when an oil company erects an offshore drilling platform, it may be legally obligated to dismantle and remove the platform at the end of its useful life. Accounting Recognition of Asset Retirement Obligations. A company must recognize an asset retirement obligation (ARO) when it has an existing legal obligation associated with the retirement of a long-lived asset and when it can reasonably estimate the amount of the liability. Companies should record the ARO at fair value. [10] Obligating events. Examples of existing legal obligations, which require recognition of a liability include, but are not limited to: • • • • Decommissioning nuclear facilities; Dismantling, restoring, and reclaiming of oil and gas properties; Certain closure, reclamation, and removal costs of mining facilities; and Closure and post-closure costs of landfills. In order to capture the benefits of these long-lived assets, the company is generally legally obligated for the costs associated with retirement of the asset, whether the company hires another party to perform the retirement activities or performs the activities with its own workforce and equipment. AROs give rise to various recognition patterns. For example, the obligation may arise at the outset of the asset's use (e.g., erection of an oil-rig), or it may build over time (e.g., a landfill that expands over time). Measurement. A company initially measures an ARO at fair value, which is defined as the amount that the company would pay in an active market to settle the ARO. While active markets do not exist for many AROs, companies should estimate fair value based on the best information available. Such information could include market prices of similar liabilities, if available. Alternatively, companies may use present value techniques to estimate fair value. Recognition and allocation. To record an ARO in the financial statements, a company includes the cost associated with the ARO in the carrying amount of the related long-lived asset, and records a liability for the same amount. It records an asset retirement cost as part of the related asset because these costs are directly related to operating the asset and are necessary to prepare the asset for its intended use. Therefore, the specific asset (e.g., mine, drilling platform, nuclear power plant) should be increased because the future economic benefit comes from the use of this productive asset. Companies should not record the capitalized asset retirement costs in a separate account because there is no future economic benefit that can be associated with these costs alone. In subsequent periods, companies allocate the cost of the ARO to expense over the period of the related asset's useful life. Companies may use the straight-line method for this allocation, as well as other systematic and rational allocations. Example of ARO accounting provisions.To illustrate the accounting for AROs, assume that on January 1, 2017, Wildcat Oil Company erected an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and remove the platform at the end of its useful life, estimated to be five years. Wildcat estimates that dismantling and removal will cost $1,000,000$1,000,000. Based on a 10 percent discount rate, the fair value of the asset retirement obligation is estimated to be $620,920 ($1,000,000×.62092)$620,920 ($1,000,000×.62092). Wildcat records this ARO as follows. January 1, 2017 Drilling Platform 620,920 Asset Retirement Obligation 620,920 During the life of the asset, Wildcat allocates the asset retirement cost to expense. Using the straight-line method, Wildcat makes the following entries to record this expense. December 31, 2017, 2018, 2019, 2020, 2021 Depreciation Expense ($620,920 ÷ 5) 124,184 Accumulated Depreciation—Plant Assets 124,184 In addition, Wildcat must accrue interest expense each period. Wildcat records interest expense and the related increase in the asset retirement obligation on December 31, 2017, as follows. December 31, 2017 Interest Expense ($620,920 × 10%) 62,092 Asset Retirement Obligation 62,092 On January 10, 2022, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the platform at a contract price of $995,000. Wildcat makes the following journal entry to record settlement of the ARO. January 10, 2022 Asset Retirement Obligation 1,000,000 Gain on Settlement of ARO 5,000 Cash 995,000 Companies provide extensive disclosure regarding environmental liabilities. In addition, some believe that companies should record more of these liabilities. The SEC recommends that companies not delay recognition of a liability due to significant uncertainty. The SEC argues that if the liability is within a range, and no amount within the range is the best estimate, then management should recognize the minimum amount of the range. That treatment is in accordance with GAAP. The SEC also believes that companies should report environmental liabilities in the balance sheet independent of recoveries from third parties. Thus, companies may not net possible insurance recoveries against liabilities but must show them separately. Because there is much litigation regarding recovery of insurance proceeds, these “assets” appear to be gain contingencies. Therefore, companies should not report these on the balance sheet.18 EVOLVING ISSUE GREENHOUSE GASES: LET'S BE STANDARD-SETTERS Ok, here is your chance to determine what to do about a very fundamental issue—how to account for greenhouse gases (GHG), often referred to as carbon emissions. Many governments are trying a market-based system, in which companies pay for an excessive amount of carbon emissions put into the atmosphere. In this market-based system, companies are granted carbon allowance permits. Each permit allows them to discharge, as an example, one metric ton of carbon dioxide (CO2). In some cases, companies may receive a number of these permits free—in other situations, they must pay for them. Other approaches require companies only to pay when they exceed a certain amount. The question is, how to account for these permits and related liabilities? For example, what happens when the permits issued by the government are free? Should an asset and revenue be reported? And if an asset is recorded, should the debit be to an intangible asset or inventory? Also, should the company recognize a liability related to its pollution? And how do we account for companies that have to purchase permits because they have exceeded their allowance? Two views seem to have emerged. The first is referred to as the net liability approach. In this approach, a company does not recognize an asset or liability. A company only recognizes a liability once GHG exceed the permits granted. To illustrate, Holton Refinery receives permits on January 1, 2017, representing the right to emit 10,000 tons of GHG for the year 2017. Other data: • • The market price of each permit at date of issuance is $10 per ton. During the year, Holton emits 12,000 tons. • The market price for a permit is now $16 per ton at December 31, 2017. Under the net liability approach, Holton records only a liability of $32,000 for the additional amount that it must pay for the 2,000 permits it must purchase at $16 per ton. Another approach is referred to as the government grant approach. In this approach, permits granted by the government are recorded at their fair value based on the initial price of $10$10 per ton. The asset recorded is an intangible asset. At the same time, an Unearned Revenue account is credited, which is subsequently recognized in income over the 2017 year. During 2017, a liability and a related emission expense of $132,000$132,000 is recognized (10,000 tons×$10+2,000 tons×$16)(10,000 tons×$10+2,000 tons×$16). The chart below compares the results of each approach on the financial statements. Net Liability Approach Income Statement Revenues $ 0 Emission expenses 32,000 $32,000 Net loss Balance Sheet Assets Liabilities $ 0 32,000 Government Grant Approach $100,000 132,000 $ 32,000 $100,000 132,000 So what do you think—net liability or government grant approach? As indicated, companies presently can report this information either way, plus some other variants which were not mentioned here. Please feel free to contact the FASB regarding your views. Self-Insurance As discussed earlier, contingencies are not recorded for general risks (e.g., losses that might arise due to poor expected economic conditions). Similarly, companies do not record contingencies for more specific future risks such as allowances for repairs. The reason: These items do not meet the definition of a liability because they do not arise from a past transaction but instead relate to future events. UNDERLYING CONCEPTS Even if companies can estimate the amount of losses with a high degree of certainty, the losses are not liabilities because they result from a future event and not from a past event. Some companies take out insurance policies against the potential losses from fire, flood, storm, and accident. Other companies do not. The reasons: Some risks are not insurable, the insurance rates are prohibitive (e.g., earthquakes and riots), or they make a business decision to self-insure. Self-insurance is another item that is not recognized as a contingency. Despite its name, self-insurance is not insurance but risk assumption. Any company that assumes its own risks puts itself in the position of incurring expenses or losses as they happen. There is little theoretical justification for the establishment of a liability based on a hypothetical charge to insurance expense. This is “as if” accounting. The conditions for accrual stated in GAAP are not satisfied prior to the occurrence of the event. Until that time there is no diminution in the value of the property. And unlike an insurance company, which has contractual obligations to reimburse policyholders for losses, a company can have no such obligation to itself and, hence, no liability either before or after the occurrence of damage. [13]19 The note shown in Illustration 13-18 from the annual report of Molson Coors Brewing Company is typical of the self-insurance disclosure. 14 Long-Term Liabilities LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Describe the nature of bonds and indicate the accounting for bond issuances. 2 Describe the accounting for the extinguishment of debt. 3 Explain the accounting for long-term notes payable. 4 Describe the accounting for the fair value option. 5 Indicate how to present and analyze long-term debt. GOING LONG The clock is ticking. Every second, it seems, someone in the world takes on more debt. The idea of a debt clock for an individual nation is familiar to anyone who has been to Times Square in New York, where the American public shortfall is revealed. The global debt clock shown below (accessed in August 2015) indicates the global figure for almost all government debts in dollar terms. Does it matter? After all, world governments owe the money to their own citizens, not to the Martians. But the rising total is important for two reasons. First, when government debt rises faster than economic output (as it has been doing in recent years), this implies more state interference in the economy and higher taxes in the future. Second, debt must be rolled over at regular intervals. This creates a recurring popularity test for individual governments, much like reality-TV contestants facing a public phone vote every week. Fail that vote, as various eurozone governments have done, and the country (and its neighbors) can be plunged into crisis. In addition to government debt, companies are issuing corporate debt at a record pace. Why this trend? For one thing, low interest rates and rising inflows into fixed-income funds have triggered record bond issuances as banks cut back lending. In addition, for some high-rated companies, it can be riskier to borrow from a bank than the bond markets. The reason: High-rated companies tend to rely on short-term commercial paper, backed up by undrawn loans, to fund working capital but are left stranded when these markets freeze up. Some are now financing themselves with longer-term bonds instead. In fact, nonfinancial companies are issuing long-term bonds at a record pace, as they look to increase long-term borrowings, lock in low interest rates, and take advantage of investor demand. The charts on the next page show the substantial increase in bonds issues as interest rates have fallen. Companies, like Phillip Morris, Medtronic, Plains All American Pipeline, and Simon Property Group, have all sold long-term bonds recently. Increases in the issuance of these bonds suggest confidence in the economy as investors appear comfortable holding such longterm investments. In addition, companies have a strong appetite for issuing these bonds because they provide a substantial cash infusion at a relatively low interest rate. Hopefully, it will work out for both the investor and the company in the long run. Sources: A. Sakoui and N. Bullock, “Companies Choose Bonds for Cheap Funds,” Financial Times (October 12, 2009); http://www.economist.com/content/global_debt_clock; V. Monga, “Companies Feast on Cheap Money Market for 30-Year Bonds, Priced at Stark Lows, Brings Out GE, UPS and Other Once-Shy Issuers,” Wall Street Journal (October 8, 2012); and M. Cherney, “Investors Scoop Up Companies' Bonds,” Wall Street Journal (March 25, 2015). REVIEW AND PRACTICE Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary review and practice problem with solution. Multiple-choice questions with annotated solutions as well as additional exercises and practice problem with solutions are also available online. BONDS PAYABLE LEARNING OBJECTIVE 1 Describe the nature of bonds and indicate the accounting for bond issuances. Long-term debt consists of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages payable, pension liabilities, and lease liabilities are examples of long-term liabilities. A corporation, per its bylaws, usually requires approval by the board of directors and the stockholders before bonds or notes can be issued. The same holds true for other types of longterm debt arrangements. Generally, long-term debt has various covenants or restrictions that protect both lenders and borrowers. The indenture or agreement often includes the amounts authorized to be issued, interest rate, due date(s), call provisions, property pledged as security, sinking fund requirements, working capital and dividend restrictions, and limitations concerning the assumption of additional debt. Companies should describe these features in the body of the financial statements or the notes if important for a complete understanding of the financial position and the results of operations. Although it would seem that these covenants provide adequate protection to the long-term debtholder, many bondholders suffer considerable losses when companies add more debt to the capital structure. Consider what can happen to bondholders in leveraged buyouts (LBOs), which are usually led by management. In an LBO of RJR Nabisco, for example, solidly rated 9⅜; percent bonds plunged 20 percent in value when management announced the leveraged buyout. Such a loss in value occurs because the additional debt added to the capital structure increases the likelihood of default. Although covenants protect bondholders, these investors can still suffer losses when debt levels get too high. Issuing Bonds A bond arises from a contract known as a bond indenture. A bond represents a promise to pay (1) a sum of money at a designated maturity date, plus (2) periodic interest at a specified rate on the maturity amount (face value). Individual bonds are evidenced by a paper certificate and typically have a $1,000 face value. Companies usually make bond interest payments semiannually, although the interest rate is generally expressed as an annual rate. The main purpose of bonds is to borrow for the long term when the amount of capital needed is too large for one lender to supply. By issuing bonds in $100, $1,000, or $10,000 denominations, a company can divide a large amount of long-term indebtedness into many small investing units, thus enabling more than one lender to participate in the loan. A company may sell an entire bond issue to an investment bank, which acts as a selling agent in the process of marketing the bonds. In such arrangements, investment banks may either underwrite the entire issue by guaranteeing a certain sum to the company, thus taking the risk of selling the bonds for whatever price they can get (firm underwriting). Or they may sell the bond issue for a commission on the proceeds of the sale (best-efforts underwriting). Alternatively, the issuing company may sell the bonds directly to a large institution, financial or otherwise, without the aid of an underwriter (private placement). Types of Bonds We define some of the more common types of bonds found in practice as follows. TYPES OF BONDS SECURED AND UNSECURED BONDS. Secured bonds are backed by a pledge of some sort of collateral. Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are secured by stocks and bonds of other corporations. Bonds not backed by collateral are unsecured. A debenture bond is unsecured. A “junk bond” is unsecured and also very risky, and therefore pays a high interest rate. Companies often use these bonds to finance leveraged buyouts. TERM, SERIAL BONDS, AND CALLABLE BONDS. Bond issues that mature on a single date are called term bonds. Issues that mature in installments are called serial bonds. Serially maturing bonds are frequently used by school or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy. Callable bonds give the issuer the right to call and redeem the bonds prior to maturity. CONVERTIBLE, COMMODITY-BACKED, AND DEEP-DISCOUNT BONDS. If bonds are convertible into other securities of the corporation for a specified time after issuance, they are convertible bonds. Two types of bonds have been developed in an attempt to attract capital in a tight money market—commodity-backed bonds and deep-discount bonds. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity, such as barrels of oil, tons of coal, or ounces of rare metal. To illustrate, Sunshine Mining, a silver-mining company, sold two issues of bonds redeemable with either $1,000 in cash or 50 ounces of silver, whichever is greater at maturity, and that have a stated interest rate of 8½ percent. The accounting problem is one of projecting the maturity value, especially since silver has fluctuated between $4 and $40 an ounce since issuance. JCPenney Company sold the first publicly marketed long-term debt securities in the United States that do not bear interest. These deep-discount bonds, also referred to as zero-interest debenture bonds, are sold at a discount that provides the buyer's total interest payoff at maturity. REGISTERED AND BEARER (COUPON) BONDS. Bonds issued in the name of the owner are registered bonds and require surrender of the certificate and issuance of a new certificate to complete a sale. A bearer or coupon bond, however, is not recorded in the name of the owner and may be transferred from one owner to another by mere delivery. INCOME AND REVENUE BONDS. Income bonds pay no interest unless the issuing company is profitable. Revenue bonds, so called because the interest on them is paid from specified revenue sources, are most frequently issued by airports, school districts, counties, tollroad authorities, and governmental bodies. WHAT DO THE NUMBERS MEAN? ALL ABOUT BONDS How do investors monitor their bond investments? One way is to review the bond listings found in the newspaper or online. Corporate bond listings show the coupon (interest) rate, maturity date, and last price. However, because corporate bonds are more actively traded by large institutional investors, the listings also indicate the current yield and the volume traded. Corporate bond listings would look like those below. Issuer Maturity Amount ($ millions) Price Coupon Yield Wal-Mart Stores, Inc. 08/15/2037 3,000 145.4 6.50 3.69 General Electric 12/06/2017 4,000 118.2 5.25 1.58 The companies issuing the bonds are listed in the first column, in this case, Wal-Mart Stores, Inc. and General Electric. Immediately after the names is a column with the maturity date, followed by the amount and price of the bonds. As indicated, Wal-Mart pays a coupon rate of 6.5 percent and yields 3.69 percent. General Electric pays a coupon rate of 5.25 percent and yields 1.58 percent. The lower yield for General Electric arises because the time to maturity is much shorter than Wal-Mart's. Also, interest rates and the bond's term to maturity have a real effect on bond prices. For example, an increase in interest rates will lead to a decline in bond values. Similarly, a decrease in interest rates will lead to a rise in bond values. The data reported in the table to the right, based on three different bond funds, demonstrate these relationships between interest rate changes and bond values. Bond Price Changes in Response to Interest Rate Changes Short-term fund (2–5 years) Intermediate-term fund (5 years) Long-term fund (10 years) Data source: The Vanguard Group. 1% Interest Rate Increase −2.5% −5 −10 1% Interest Rate Decrease +2.5% +5 +10 Another factor that affects bond prices is the call feature, which decreases the value of the bond. Investors must be rewarded for the risk that the issuer will call the bond if interest rates decline, which would force the investor to reinvest at lower rates. Valuation and Accounting for Bonds Payable The issuance and marketing of bonds to the public does not happen overnight. It usually takes weeks or even months. First, the issuing company must arrange for underwriters that will help market and sell the bonds. Then, it must obtain the Securities and Exchange Commission's approval of the bond issue, undergo audits, and issue a prospectus (a document which describes the features of the bond and related financial information). Finally, the company must generally have the bond certificates printed. Frequently, the issuing company establishes the terms of a bond indenture well in advance of the sale of the bonds. Between the time the company sets these terms and the time it issues the bonds, the market conditions and the financial position of the issuing corporation may change significantly. Such changes affect the marketability of the bonds and thus their selling price. The selling price of a bond issue is set by the supply and demand of buyers and sellers, relative risk, market conditions, and the state of the economy. The investment community values a bond at the present value of its expected future cash flows, which consist of (1) interest and (2) principal. The rate used to compute the present value of these cash flows is the interest rate that provides an acceptable return on an investment commensurate with the issuer's risk characteristics. The interest rate written in the terms of the bond indenture (and often printed on the bond certificate) is known as the stated, coupon, or nominal rate. The issuer of the bonds sets this rate. The stated rate is expressed as a percentage of the face value of the bonds (also called the par value, principal amount, or maturity value). If the rate employed by the investment community (buyers) differs from the stated rate, the present value of the bonds computed by the buyers (and the current purchase price) will differ from the face value of the bonds. The difference between the face value and the present value of the bonds determines the actual price that buyers pay for the bonds. This difference is either a discount or premium.1 • • If the bonds sell for less than face value, they sell at a discount. If the bonds sell for more than face value, they sell at a premium. The rate of interest actually earned by the bondholders is called the effective yield or market rate. If bonds sell at a discount, the effective yield exceeds the stated rate. Conversely, if bonds sell at a premium, the effective yield is lower than the stated rate. Several variables affect the bond's price while it is outstanding, most notably the market rate of interest. There is an inverse relationship between the market interest rate and the price of the bond. Here we consider an example to illustrate the computation of the present value of a bond issue. Assume that ServiceMaster issues $ 100,000 in bonds, due in five years with 9 percent interest payable annually at year-end. At the time of issue, the market rate for such bonds is 11 percent. The time diagram in Illustration 14-1 depicts both the interest and the principal cash flows. ILLUSTRATION 14-1 Time Diagram for Bond Cash Flows The actual principal and interest cash flows are discounted at an 11 percent rate for five periods, as shown in Illustration 14-2. ILLUSTRATION 14-2 Present Value Computation of Bond Selling at a Discount Present value of the principal: $100,000 × .59345 (Table 6-2) $59,345.00 Present value of the interest payments: $9,000 × 3.69590 (Table 6-4) 33,263.10 Present value (selling price) of the bonds $92,608.10 By paying $92,608.10 at the date of issue, investors earn an effective rate or yield of 11 percent over the five-year term of the bonds. These bonds would sell at a discount of $7,391.90 ($100,000−$92,608.10)$7,391.90 ($100,000−$92,608.10). The price at which the bonds sell is typically stated as a percentage of the face or par value of the bonds. For example, the ServiceMaster bonds sold for 92.6 (92.6% of par). If ServiceMaster had received $102,000, then the bonds sold for 102 (102% of par). When bonds sell at less than face value, it means that investors demand a rate of interest higher than the stated rate. Usually this occurs because the investors can earn a greater rate on alternative investments of equal risk. They cannot change the stated rate, so they refuse to pay face value for the bonds. Thus, by changing the amount invested, they alter the effective rate of return. The investors receive interest at the stated rate computed on the face value, but they actually earn at an effective rate that exceeds the stated rate because they paid less than face value for the bonds. (Later in the chapter, in Illustrations 14-7 and 14-8 (page 728), we show an illustration for a bond that sells at a premium.) WHAT DO THE NUMBERS MEAN? HOW'S MY RATING? Two major publication companies, Moody's Investors Service and Standard & Poor's Corporation, issue quality ratings on every public debt issue. The table to the right summarizes the ratings issued by Standard & Poor's, along with historical default rates on bonds with different ratings. Original rating AAA AA A BBB BB B CCC Default rate 0.52% 1.31 2.32 6.64 19.52 35.76 54.38 Data source: Standard & Poor’s Corp. As expected, bonds receiving the highest quality rating of AAA have the lowest historical default rates. Bonds rated below BBB, which are considered below investment grade (“junk bonds”), experience default rates ranging from 20 to 50 percent. Debt ratings reflect credit quality. The market closely monitors these ratings when determining the required yield and pricing of bonds at issuance and in periods after issuance, especially if a bond's rating is upgraded or downgraded. Unfortunately, the median rating of companies assessed by Standard & Poor's has recently fallen from A to BBB. The BBB rating is the lowest possible “investment grade” or, to put it another way, is just one notch above “junk” bond status. It should be noted that investors who seek triple-A debt are running out of options. Standard & Poor's recently gave its top rating to just three U.S. industrial companies: ExxonMobil, Johnson & Johnson, and Microsoft. Indeed, the overall decline in ratings can be explained in part by the growing issuance of CCCrated debt in a variety of industry sectors, as shown in the chart to the right. Years of low interest rates have encouraged some of the riskiest corporate borrowers to tap yield-hungry investors to finance their growth, spurring issuance of debt that comes with triple-C credit ratings. For investors willing to shoulder the burden of those extra risks in exchange for heftier returns, CCCrated bonds have been alluring. Sources: A. Borrus, M. McNamee, and H. Timmons, “The Credit Raters: How They Work and How They Might Work Better,” BusinessWeek (April 8, 2002), pp. 38–40; Standard and Poor's, “Fallen Angel Activity,” Global Fixed Income Research (February 6, 2007); M. Krantz, “Downgrade! Only 3 U.S. Companies Now Rated AAA,” USA Today (April 11, 2014); and T. Alloway, “A Towering Bond Trade Has Been Quietly Falling Apart,” Bloomberg.com (August 3, 2015). Bonds Issued at Par on Interest Date When a company issues bonds on an interest payment date at par (face value), it accrues no interest. No premium or discount exists. The company simply records the cash proceeds and the face value of the bonds. To illustrate, if Buchanan Company issues at par 10-year term bonds with a par value of $800,000, dated January 1, 2017, and bearing interest at an annual rate of 10 percent payable semiannually on January 1 and July 1, it records the following entry. Cash 800,000 Bonds Payable 800,000 Buchanan records the first semiannual interest payment of $40,000 ($800,000×.10×1/2)$40,000 ($800,000×.10×12) on July 1, 2017, as follows. Interest Expense 40,000 Cash 40,000 It records accrued interest expense at December 31, 2017 (year-end), as follows. Interest Expense 40,000 Interest Payable 40,000 Bonds Issued at Discount or Premium on Interest Date If Buchanan Company issues the $800,000 of bonds on January 1, 2017, at 97 (meaning 97% of par), it records the following issuance. Cash ($800,000 × .97) 776,000 Discount on Bonds Payable 24,000 Bonds Payable 800,000 Recall from our earlier discussion that because of its relation to interest, companies amortize the discount and charge it to interest expense over the period of time that the bonds are outstanding. The straight-line method amortizes a constant amount each interest period (in this case 20 interest periods).2 For example, using the bond discount of $24,000, Buchanan amortizes $1,200 to interest expense each period for 20 periods ($24,000÷20)($24,000÷20). Buchanan records the semiannual interest payments of $40,000 ($800,000 × 10% × 1/2)$40,000 ($800,000 × 10% × 12) and the bond discount for the first year of the bond as indicated in Illustration 14-3. ILLUSTRATION 14-3 Straight-Line Amortization July 1, 2017 Interest Expense 41,200 Discount on Bonds Payable 1,200 Cash 40,000 December 31, 2017 Interest Expense Discount on Bonds Payable Payable 41,200 1,200 40,000 At the end of the first year, 2017, the balance in the Discount on Bonds Payable account is $21,600 ($24,000−$1,200−$1,200)$21,600 ($24,000−$1,200−$1,200). Over the term of the bonds, the balance in Discount on Bonds Payable will decrease by the same amount until it has zero balance at the maturity date of the bonds. If instead of issuing the bonds on January 1, 2017, Buchanan dates and sells the bonds on October 1, 2017, and if the fiscal year of the corporation ends on December 31, the discount amortized during 2017 would be only 3/12 of 1/10 of $24,000, or $600. Buchanan must also record three months of accrued interest on December 31. Premium on Bonds Payable is accounted for in a manner similar to that for Discount on Bonds Payable. If Buchanan dates and sells 10-year bonds with a par value of $800,000 on January 1, 2017, at 103, it records the issuance as follows. Cash ($800,000 × 1.03) 824,000 Premium on Bonds Payable Bonds Payable 24,000 800,000 With the bond premium of $24,000, Buchanan amortizes $1,200 to interest expense each period for 20 periods ($24,000÷20)($24,000÷20). Buchanan records the first semiannual interest payment of $40,000 ($800,000 × 10% × 1/2)$40,000 ($800,000 × 10% × 12) and the bond premium on July 1, 2017, as follows. Interest Expense 38,800 Premium on Bonds Payable 1,200 Cash 40,000 At December 31, 2017, Buchanan makes the following adjusting entry. Interest Expense 38,800 Premium on Bonds Payable 1,200 Interest Payable 40,000 Amortization of a discount increases interest expense. Amortization of a premium decreases interest expense. Later in the chapter, we discuss amortization of a discount or premium under the effective-interest method. The issuer may call some bonds at a stated price after a certain date. This call feature gives the issuing corporation the opportunity to reduce its bonded indebtedness or take advantage of lower interest rates. Whether callable or not, a company must amortize any premium or discount over the bond's life to maturity because early redemption (call of the bond) is not a certainty. Bonds Issued Between Interest Dates Companies usually make bond interest payments semiannually, on dates specified in the bond indenture. When companies issue bonds on other than the interest payment dates, buyers of the bonds will pay the seller the interest accrued from the last interest payment date to the date of issue. The purchasers of the bonds, in effect, pay the bond issuer in advance for that portion of the full six-months' interest payment to which they are not entitled because they have not held the bonds for that period. Then, on the next semiannual interest payment date, purchasers will receive the full six-months' interest payment. To illustrate, assume that on March 1, 2017, Taft Corporation issues 10-year bonds, dated January 1, 2017, with a par value of $800,000. These bonds have an annual interest rate of 6 percent, payable semiannually on January 1 and July 1. Because Taft issues the bonds between interest dates, it records the bond issuance at par plus accrued interest as follows. Cash 808,000 Bonds Payable Interest Expense ($800,000 × .06 × 2/12) (Interest Payable might be credited instead) 800,000 8,000 The purchaser advances two months' interest. On July 1, 2017, four months after the date of purchase, Taft pays the purchaser six months' interest. Taft makes the following entry on July 1, 2017. Interest Expense 24,000 Cash 24,000 The Interest Expense account now contains a debit balance of $16,000, which represents the proper amount of interest expense—four months at 6 percent on $800,000. The illustration above was simplified by having the January 1, 2017, bonds issued on March 1, 2017, at par. If, however, Taft issued the 6 percent bonds at 102, its March 1 entry would be: Cash [($800,000 × 1.02) + ($800,000 × .06 × 2/12)] 824,000 Bonds Payable Premium on Bonds Payable ($800,000 × .02) Interest Expense 800,000 16,000 8,000 Taft would amortize the premium from the date of sale (March 1, 2017), not from the date of the bonds (January 1, 2017). That is, the amortization period is 118 months [120 (10 × 12) minus two months since issuance]. As a result, the premium amortization at July 1, 2017, is $542.37 [($16,000÷$118) × 4]$542.37 [($16,000÷$118) × 4]. Effective-Interest Method The preferred procedure for amortization of a discount or premium is the effective-interest method (also called present value amortization). Under the effective-interest method, companies: 1.Compute bond interest expense first by multiplying the carrying value (book value) of the bonds at the beginning of the period by the effective-interest rate.3 2.Determine the bond discount or premium amortization next by comparing the bond interest expense with the interest (cash) to be paid. INTERNATIONAL PERSPECTIVE IFRS requires the use of the effective-interest method. GAAP permits the use of the straight-line method if not materially different than the effective-interest method. Illustration 14-4 depicts graphically the computation of the amortization. ILLUSTRATION 14-4 Bond Discount and Premium Amortization Computation The effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds. Since the percentage is the effective rate of interest incurred by the borrower at the time of issuance, the effective-interest method provides a move relevant measure of interest expense than the straight-line method.4 Both the effective-interest and straight-line methods result in the same total amount of interest expense over the term of the bonds. However, when the annual amounts are materially different, generally accepted accounting principles require use of the effective-interest method. [2] Bonds Issued at a Discount. To illustrate amortization of a discount under the effective-interest method, Evermaster Corporation issued $100,000 of 8 percent term bonds on January 1, 2017, due on January 1, 2022, with interest payable each July 1 and January 1. Because the investors required an effective-interest rate of 10 percent, they paid $92,278 for the $100,000 of bonds, creating a $7,722 discount. Evermaster computes the $7,722 discount as follows.5 ILLUSTRATION 14-5 Computation of Discount on Bonds Payable Maturity value of bonds payable Present value of $100,000 due in 5 years at 10%, interest payable semiannually (Table 6-2); FV(PVF10,5%); ($100,000 × .61391) Present value of $4,000 interest payable semiannually for 5 years at 10% annually (Table 6-4); R(PVF-OA10,5%); ($4,000 × 7.72173) Less: Proceeds from sale of bonds Discount on bonds payable The five-year amortization schedule appears in Illustration 14-6. $100,000 $61,391 30,887 92,278 $ 7,722 ILLUSTRATION 14-6 Bond Discount Amortization Schedule SCHEDULE OF BOND DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS 5-YEAR, 8% BONDS SOLD TO YIELD 10% Date Cash Paid Interest Expense Discount Amortized Carrying of Bonds Amount 1/1/17 $ 92,278 a b c 7/1/17 $ 4,000 $ 4,614 $ 614 92,892d 1/1/18 4,000 4,645 645 93,537 7/1/18 4,000 4,677 677 94,214 1/1/19 4,000 4,711 711 94,925 7/1/19 4,000 4,746 746 95,671 1/1/20 4,000 4,783 783 96,454 7/1/20 4,000 4,823 823 97,277 1/1/21 4,000 4,864 864 98,141 7/1/21 4,000 4,907 907 99,048 1/1/22 4,000 4,952 952 100,000 $40,000 $47,722 $7,722 a $4,000 = $100,000 × .08 × 6/12 b c $4,614 = $92,278 × .10 × 6/12 $614 = $4,614 − $4,000 d $92,892 = $92,278 + $614 See the FASB Codification References (page 767). Evermaster records the issuance of its bonds at a discount on January 1, 2017, as follows. Cash 92,278 Discount on Bonds Payable 7,722 Bonds Payable 100,000 It records the first interest payment on July 1, 2017, and amortization of the discount as follows. Interest Expense 4,614 Discount on Bonds Payable Cash 614 4,000 Evermaster records the interest expense accrued at December 31, 2017 (year-end), and amortization of the discount as follows. Interest Expense 4,645 Interest Payable 4,000 Discount on Bonds Payable 645 Bonds Issued at a Premium. Now assume that for the bond issue by Evermaster Corporation (page 727), investors are willing to accept an effective-interest rate of 6 percent. In that case, they would pay $108,530 or a premium of $8,530, computed as follows. ILLUSTRATION 14-7 Computation of Premium on Bonds Payable Maturity value of bonds payable Present value of $100,000 due in 5 years at 6%, interest payable semiannually (Table 6-2); FV(PVF10,3%); ($100,000 × .74409) Present value of $4,000 interest payable semiannually for 5 years at 6% annually (Table 6-4); R(PVF-OA10,3%); ($4,000 × 8.53020) Less: Proceeds from sale of bonds Premium on bonds payable $100,000 $74,409 34,121 108,530 $ 8,530 The five-year amortization schedule appears in Illustration 14-8. ILLUSTRATION 14-8 Bond Premium Amortization Schedule SCHEDULE OF BOND PREMIUM AMORTIZATION EFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS 5-YEAR, 8% BONDS SOLD TO YIELD 6% Date Cash Paid Interest Expense Premium Amortized 1/1/17 7/1/17 $ 4,000a $ 3,256b $ 744c 1/1/18 4,000 3,234 766 7/1/18 4,000 3,211 789 1/1/19 4,000 3,187 813 7/1/19 4,000 3,162 838 Carrying Amount of Bonds $108,530 107,786d 107,020 106,231 105,418 104,580 1/1/20 7/1/20 1/1/21 7/1/21 1/1/22 4,000 3,137 4,000 3,112 4,000 3,085 4,000 3,057 4,000 3,029 $40,000 $31,470 a $4,000 = $100,000 × .08 × 6/12 b c 863 888 915 943 971 $8,530 103,717 102,829 101,914 100,971 100,000 $3,256 = $108,530 × .06 × 6/12 $744 = $4,000 − $3,256 d $107,786 = $108,530 − $744 Evermaster records the issuance of its bonds at a premium on January 1, 2017, as follows. Cash 108,530 Premium on Bonds Payable 8,530 Bonds Payable 100,000 Evermaster records the first interest payment on July 1, 2017, and amortization of the premium as follows. Interest Expense 3,256 Premium on Bonds Payable 744 Cash 4,000 Evermaster should amortize the discount or premium as an adjustment to interest expense over the life of the bond in such a way as to result in a constant rate of interest when applied to the carrying amount of debt outstanding at the beginning of any given period. Accruing Interest. In our previous examples, the interest payment dates and the date the financial statements were issued were essentially the same. For example, when Evermaster sold bonds at a premium, the two interest payment dates coincided with the financial reporting dates. However, what happens if Evermaster wishes to report financial statements at the end of February 2017? In this case, the company prorates the premium by the appropriate number of months, to arrive at the proper interest expense, as follows. ILLUSTRATION 14-9 Computation of Interest Expense Interest accrual ($4,000 × 2/6)($4,000 × 26) $1,333.33$1,333.33 Premium amortized ($744 × 2/6)($744 × 26) (248.00)(248.00) Interest expense (Jan.–Feb.) $1,085.33$1,085.33 Evermaster records this accrual as follows. Interest Expense 1,085.33 Premium on Bonds Payable 248.00 Interest Payable 1,333.33 If the company prepares financial statements six months later, it follows the same procedure. That is, the premium amortized would be as follows. ILLUSTRATION 14-10 Computation of Premium Amortization Premium amortized (March–June) ($744 × 4/6)($744 × 46) $496.00$496.00 Premium amortized (July–August) ($766 × 2/6)($766 × 26) 255.33255.33 Premium amortized (March–August) $751.33$751.33 The interest-accrual computation is much simpler if the company uses the straight-line method. For example, the total premium is $8,530, which Evermaster allocates evenly over the five-year period. Thus, premium amortization per month is $142.17 ($8,530÷60 months)$142.17 ($8,530÷60 months). Classification of Discount and Premium. Discount on bonds payable is not an asset. It does not provide any future economic benefit. In return for the use of borrowed funds, a company must pay interest. A bond discount means that the company borrowed less than the face or maturity value of the bond. It therefore faces an actual (effective) interest rate higher than the stated (nominal) rate. Conceptually, discount on bonds payable is a liability valuation account. That is, it reduces the face or maturity amount of the related liability.6 This account is referred to as a contra account. Similarly, premium on bonds payable has no existence apart from the related debt. The lower interest cost results because the proceeds of borrowing exceed the face or maturity amount of the debt. Conceptually, premium on bonds payable is a liability valuation account. It adds to the face or maturity amount of the related liability.7 This account is referred to as an adjunct account. As a result, companies report bond discounts and bond premiums as a direct deduction from or addition to the face amount of the bond. Extinguishment of Debt LEARNING OBJECTIVE 2 Describe the accounting for the extinguishment of debt. How do companies record the payment of debt—often referred to as extinguishment of debt? If a company holds the bonds (or any other form of debt security) to maturity, the answer is straightforward: The company does not compute any gains or losses. It will have fully amortized any premium or discount at the date the bonds mature. As a result, the carrying amount will equal the maturity (face) value of the bond. As the maturity or face value will also equal the bond’s fair value at that time, no gain or loss exists. In some cases, a company extinguishes debt before its maturity date.8 The amount paid on extinguishment or redemption before maturity, including any call premium and expense of reacquisition, is called the reacquisition price. On any specified date, the net carrying amount of the bonds is the amount payable at maturity, adjusted for unamortized premium or discount. Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess of the reacquisition price over the net carrying amount is a loss from extinguishment. At the time of reacquisition, the unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition date. To illustrate, assume that on January 1, 2010, General Bell Corp. issued at 95 bonds with a par value of $800,000, due in 20 years. Eight years after the issue date, General Bell calls the entire issue at 101 and cancels it.9 At that time, the unamortized discount balance is $24,000. Illustration 14-11 indicates how General Bell computes the loss on redemption (extinguishment).

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Intermediate Accounting
Institutional Affiliation




Intermediate Accounting
Gain and Loss Contingencies
Identify the criteria used to account for and disclose gain and loss contingencies
Loss contingency may be referred to as a charge to expense to what is commonly referred
to as a probable future event. The contingency is responsible in giving the readers of a particular
organization’s financial statement. A contingent gain on the other hand is assets that are not
necessarily recorded in the books of account (Harrison, & Ng 2016). The widely used criteria
used to account for the contingencies is the reporting on the balance sheet and footnotes of the
organization’s financial statement.
Explain the accounting for different types of loss contingencies
The accounting of loss contingencies happens in a situation where the outcome is
uncertain, but there exists the possibility of a loss being created. The accounting is done to
recognize the losses that are probable. Additionally, the amount of loss is also reasonably
Describe the nature, type, and valuation of current liabilities
Current liabilities may be defined as the short term obligations listed in an organization’s
balance sheet and are due for settlement within one year. Types of current liabilities include
interest payable, bills payable, accrued expenses as well as short-term loans. Typically,
companies calculate the worth of liabilities at their present value of the future cash flows.



Current liabilities, as opposed to noncurrent liabilities, are short-term debts that are due for not
more than one year.
Long-term Debt
To begin with, it is essential to enquire what the money is needed for as this will form the
bases on whether to issue the loan or not. Secondly, the amount that is asked for is evaluated to
see if it’s reasonable and whether the current score of the business matches the amount asked for.
Additionally, a report on industry risks and that on the cash flow is done to be in a position to
evaluate the future of the bu...

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