Other Liabilities

1
Other Liabilities
21
Other liabilities both current and long term
2
Liabilities -definition

• The FASB definition of a liability includes these
  3 essential elements
• It is an obligation in effect that must be
  settled by giving up cash, goods or services in
  the future.
• It is an obligation that cannot be avoided.
• The event that created the obligation has already
  occurred.

• In this chapter we will study several liabilities
  that could meet this definition but may
• Require an estimate as to
• the size of the liability,
• the date it must be paid and
• the party to whom it will be paid
• Exhibit uncertainty as to whether the liability
  will occur

3
Objective 21.1 Account for estimated liabilities
involving warranties and rebates
Estimated liabilities are known obligations of an
uncertain amount. They often also exhibit
uncertainty as to the date they must be paid and
the party to whom they will be paid.
O21.1
4
Account for estimated liabilities involving
warranties and rebates
Firms often guarantee their products and services
under a warranty agreement. Based on the expected
occurrence of claims, they must follow the
Matching Concept and expense the warranty repair
or replacement in the same fiscal period as the
sales that involved the warranty.
WARRANTY We guarantee. . .
O21.1
5
Account for estimated liabilities involving
warranties and rebates
Firms also offer inducements to generate sales
and develop customer loyalty through the use of
marketing innovations such as cash rebates. This
additional expense, must follow the Matching
Concept and be included in the same fiscal period
as the sales that these inducements helped
generate.
25 Rebate With the purchase of. . .
O21.1
6
Account for estimated liabilities involving
warranties and rebates

• Problem -When the warranty or rebate is expensed,
  the firm doesnt know precisely
• Who will be paid
• How much or how many will be paid
• When they will be paid

Solution -Estimate the warranty and rebate
expense expected
O21.1
7
Account for estimated liabilities involving
warranties and rebates

• Warranty liabilities
• After sale obligations arising from guaranty
  agreements for products and services
• Estimates must be used to predict expected
  warranty claims
• Warranty liability and expense must be recorded
  in the same period as sales subject to the
  warranty

WARRANTY We guarantee. . .
O21.1
8
Account for estimated liabilities involving
warranties and rebates

• Rebate liabilities
• Subject to a sale, cash, product or service
  obligation to a customer
• Estimates must be used to predict amounts that
  must be paid based on expected redemption rates
• Rebate liability and expense must be recorded in
  the same period as the sales subject to the
  incentive

25 Rebate With the purchase of. . .
O21.1
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Example WARRANTYOn January 1, Greenline Engine
Rebuilders began to offer a 2 year 20,000 mile
parts and labor warranty on their rebuilt auto
and truck engines. Management estimates that
warranty expenses will average 3 of net sales.
As of December 31, net sales 2,350,000.
Estimated warranty claims are 2,350,000 x 3
70,500
Greenline will report 70,500 less net income as
a result of this adjustment.
O21.1
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Example WARRANTYIn January following the first
year of the warranty agreement, a customer
submitted a claim for 500 for warranty repairs
made on a Greenline engine.  
No change in net income as a result of this
transaction
Note that the debit does not go to an expense
account, it reduces the Warranty Liability. This
obligation has already been expensed in the prior
fiscal period.
O21.1
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Example REBATE On January 1, YardMax Tools began
to offer a 25 mail-in rebate on the purchase of
their new garden tiller. Management estimates
that 40 of customers will submit the mail-in
rebate. The sales price for the new tiller is
425.
Sales totaled 850,000. Estimated rebate
expense 850,000/425 2000 tillers x 40
x 25 20,000
YardMax will report 20,000 less net income
O21.1
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Objective 21.2 Account for estimated liabilities
arising from compensated absences and bonus plans

• Compensated absence plans include
• Vacations
• Sick pay
• Holidays
• Family leave
• earned by employees

O21.2
13
Account for estimated liabilities arising from
compensated absences and bonus plans

• FASB rules indicate these expenses should be
  accrued if the following conditions are met
• The obligation to compensate for absences arises
  from services already rendered by the employee.
• The obligation is related to rights for time off
  that vest or accumulate
• Payment is probable
• Amounts can be reasonably estimated

O21.2
14
Account for estimated liabilities arising from
compensated absences and bonus plans
Vested rights exist when the employee has a
right to the benefit even if terminated
Accumulated rights exists when benefits can be
carried forward into future periods if not used
in the current period
O21.2
15
Compensated absences -example
Consider start up firm Barrier Systems who began
operation on July 1 (FYE 6/30). Barrier has 10
employees who earn, on average, 625 per week.
During the year employees earned 20 weeks of paid
vacation and none was used. 625 x 10 employees
x 20 weeks 125,000 
O21.2
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Compensated absences -example
In the first month of the subsequent fiscal year,
employee Ralph Tonga takes his 2 week vacation.
His weekly wage, net of all payroll costs and
deductions, is 725.  
Additional entries (i.e. debits to the Vacation
Wages Payable credits to various payroll
payable accounts) for employee deductions and the
employer payroll costs would be necessary to
complete the payroll recording. (See Chapter 8)
O21.2
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Bonus agreements -example
Ridlow Corporations bonus plan pools 20 of net
profits (after the expense of the profit sharing
is deducted) for distribution to all employees
weighted by their total annual compensation.
Ridlows net income before any bonus plan
deductions is 1,500,000.   Let B equal the
amount of the bonus, then B 20 x
(1,500,000B) B 300,000 - .20B 1.20B
300,000 B 250,000
O21.2
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Objective 21.3 Explain accounting issues
involving estimated and deferred income tax

• The regular C-corporation is subject to federal
  income taxes which must be accounted for on the
  corporate financial statements
• Estimates are recorded during the tax year based
  on anticipated taxable income levels
• Corporations are required to make estimated
  quarterly income tax payments to the IRS to avoid
  penalties

O21.3
19
Explain accounting issues involving estimated and
deferred income tax
At month end, Nappy Corp estimates the first
quarterly tax payments due April 15 to be
22,000.
Note that the estimate is expensed
O21.3
20
Explain accounting issues involving estimated and
deferred income tax
On April 15, the tax payment is made
The payable is satisfied with the cash payment
O21.3
21
Explain accounting issues involving estimated and
deferred income tax

• Deferred Income Tax Liabilities
• income under GAAP and income under IRS rules is
  usually different
• most differences are temporary due to timing
  issues
• over longer periods of time (years) different
  income amounts between IRS and GAAP due to timing
  are eliminated
• except for some permanent differences

O21.3
22
Explain accounting issues involving estimated and
deferred income tax
Consider the different income for the same year
under GAAP and IRS for Vision Corporation
O21.3
23
Explain accounting issues involving estimated and
deferred income tax
Why is the income (GAAP vs IRS) different?

• Some examples of permanent reasons are
• Permanent GAAP IRS
• Is municipal bond interest revenue?
• Are fines for legal violations expenses?

For temporary and permanent reasons.
No
Yes
No
Yes
O21.3
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Explain accounting issues involving estimated and
deferred income tax
Why is the income (GAAP vs IRS) different?
Due to temporary timing differences in the
recognition of revenues and expenses

• Some examples of temporary reasons are
  (eventually results will be same for GAAP IRS)
• Straight line depreciation could be used for GAAP
  but an accelerated depreciation for IRS
• Uncollectible account expense and warranty
  expense is accrued under GAAP but IRS only allows
  these to be expensed when cash is actually paid

O21.3
25
Explain accounting issues involving estimated and
deferred income tax
These differences often result in a deferred
income tax liability (or asset)
Keep in mind that we are preparing GAAP
statements here
GAAP statements
We are obliged to record the federal income tax
expense based on the 30,000 GAAP income NOT the
10,000 IRS taxable income.
O21.3
26
Explain accounting issues involving estimated and
deferred income tax
If the tax rate is 15 for Vision Corporation,
this would require 15 x 30,000 4,500 debit
to income tax expense
The amount currently due (must be paid this
period) to the IRS 15 x 10,000 1,500
The balancing entry of 3,000 is the deferred
amount (will be paid in future years)
O21.3
27
Explain accounting issues involving estimated and
deferred income tax
These differences can also result in a deferred
income tax asset
Consider Cascade Corporation net income of
20,000 under GAAP and 50,000 under IRS.
The deferred tax asset will be used up in future
periods.
O21.3
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Objective 21.4 Explain accounting issues
involving contingent liabilities
Contingent liabilities are potential liabilities
arising from an existing set of circumstances
Example Consider a product defect lawsuit
pending against PNC Corporation. If the firm
loses the suit they may be required to pay
substantial amounts.
O21.4
29
Explain accounting issues involving contingent
liabilities
Depending on how future events unfold, PNC
Corporation could suffer a loss based on the
outcome of the lawsuit.
The loss is uncertain until the lawsuit is over
O21.4
30
Explain accounting issues involving contingent
liabilities

• FASB rules regarding the recording of contingent
  liabilities are based on two questions
• What are the chances the event will occur?
• Can the size of the potential loss be reasonably
  estimated?
•  

O21.4
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Explain accounting issues involving contingent
liabilities

• FASB assigns three ranges of possibility to the
  first question.
• Probable The future event is likely to occur
• Reasonably possible The chance of the event
  occurring is less than likely but more than
  remote
• Remote The chance of the future event occurring
  is slight

O21.4
32
Explain accounting issues involving contingent
liabilities
Only one of these situations require the
liability to be recorded
O21.4
33
Explain accounting issues involving contingent
liabilities
Assuming that the PNC corporation product defect
lawsuit has been determined to be both probable
and can be reasonably estimated as a 500,000
potential loss. . .
The loss is still probable, not 100 certain
O21.4
34
Explain accounting issues involving contingent
liabilities

• Also
• A set of circumstances could possibly result in a
  gain (i.e. the firm began a lawsuit against
  another party for damages)
• If the firm wins, a gain could result
• However, GAAP rules lean toward the Conservatism
  Concept in the case of gains and they are not
  recorded until they actually occur

O21.4
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Objective 21.5 Analysis Compute and explain
average working capital as a percentage of sales
Working capital answers the following question
How many dollars of current assets would remain
if all current liabilities were paid using
current assets? The higher the number, the more
liquidity is displayed by the balance sheet.
Working Capital
Current Assets
Current Liabilities
O21.5
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Analysis Compute and explain average working
capital as a percentage of sales
Average working capital Working capital
(beg.) Working capital (ending) 2  
Average working capital as a percentage of sales
Average Working Capital
Sales
O21.5
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Analysis Compute and explain average working
capital as a percentage of sales
Average working capital as a percentage of
sales answers the question What level of
working capital was necessary to achieve the
reported sales for the year?
Average Working Capital
Average working capital as a percentage of sales
Sales
O21.5
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Example
O21.5
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End Unit 21