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Introduction on liabilities
Liabilities are obligations. For U.S. GAAP accounting, liabilities are broadly defined as being
- probable future sacrifices of economic benefits
- that arise from present obligations
- that result from past transactions
Note while most liabilities involve known amounts of obligations to be paid in cash on specific dates, the definition is open to many other obligations where amounts and timing are not certain.
Current vs. long-term liabilities
Current liabilities are often loosely defined as liabilities that must be paid within one year. For firms having w:operating cycles longer than one year, current liabilities are defined as those which must be paid during that longer period. The more correct definition, however, is that current liabilities are liabilities that will by settled by current assets or by the creation of other current liabilities.
Typical short term liabilities include accounts payable, short-term notes payable, commercial paper, and trade notes payable.
For example, consider what happens in the last year of a long term note, when the full face amount of the bond will become payable. Technically, it would appear the full amount due within one year is a current liability. However, if a new note is in process, and various terms are met, it is allowable to classify the full value as being a long term note. It will be replaced by a new long term note. If the full amount will be fully paid off by cash or by creating new short-term liabilities such as a new short-term note, then the full amount is to be recorded as a current liability.
Other long-term term obligations that can be classified as current are those that are callable by the creditor. When a debt becomes callable in the upcoming year (or operating cycle, if longer), the debt is required to be classified as current, even if it is not expected to be called. Debt should also be classified as current if the creditor has the right to demand payment because of an existing violation of a provision of a debt agreement. Situations in which debt is not yet callable but will be callable within the year if a violation is not corrected within a specified grace period are current, unless it's probable that the violation will be collected or waived.
The classification of liabilities as either current or long-term is important because it helps investors and creditors assess the relative risk of a business's liabilities.
Refinancing Short-Term Liabilities
The purpose of refinancing short term liabilities is to remove the expectation of using working capital during the ensuing fiscal year. This improves important financial ratios, such as the current ratio, making the organization more financially appealing.
Current Ratio - Current Assets/Current Liabilities
Conditions for Long-Term Refinancing
Certain conditions must be met for an organization to refinance on a long-term basis. According to FASB codification 470-10-45-14 and SFAS No. 6 (under the old system), a short-term liability can be excluded from current liabilities if:
(i) The entity intends to refinance the obligation on a long term basis.
and(ii)The intent to refinance the short-term obligation on a long-term basis is supported by an ability to consummate the refinancing.
When Short-Term Liabilities intended for Refinancing are Repaid Early
Often an entity expresses intent to refinance short-term liabilities with long-term debt, but it ends up repaying the obligation before the issuance of the long-term debt. According to FASB codification 470-10-45-15 or SFAS No. 6, the short-term liability remains current, even if the funds used to repay are replenished by the long-term debt.
1. Which of the following liabilities should not be classified as current? a. accounts payable b. short-term notes payable c. short-term commercial paper that is expected to be refinanced with a long-term bond d. long-term debt that is callable within a year
2. True/False: A long-term note payable that has become callable within a year increases the current ratio.
Book Bonanza is a publishing company with the following financial obligations: -Accounts payable of $50,000 -Long-term notes payable of $100,000 in which half of them become callable within the year -A long-term loan of $200,000 in which Book Bonanza is in violation of a debt agreement provision It is probable that it will be corrected within the grace period -$25,000 of short-term commercial paper that will be refinanced with a long-term loan
3. Calculate the total current liabilities
4. Calculate the total non-current liabilities
5. Pizza fountain has $50,000 in short-term commercial paper that is intends to refinance with a long term loan of $300,000 in Dec. 2009. Pizza Fountain repaid half of commercial paper with excess cash in Oct. 2009. $25,000 of the loan replenished working capital, $25,000 was used to repay the commercial paper, and $250,000 was used to purchase equipment. Calculate total current and non-current liabilities related to these transactions.
1. c 2. false 3. $100,000 4. $275,000 5. current- $25,000 non-current- $275,000
Short-term loans offered by a bank based by a prearranged line of credit. Compensating balances are sometimes required to be on deposit with the lending bank and is usually calculated as a percentage of the line of credit.
Accounting for bonds involves recording, at issue, both the nominal or face value of bonds issued, and also the amount of cash proceeds actually yielded by their sale. The difference between these is recorded as a premium on bonds (when bond proceeds are higher than face value of bonds) or as a discount on bonds (when proceeds are lower than face value). The difference arises because the bonds can only be sold for what investors are willing to pay. Only rarely will the effective interest rate equal the stated interest rate (and then there will be no premium or discount). When investors pay less than the face value of bonds, they are effectively demanding an "effective interest rate" that is higher than the stated interest rate. When they pay more than face value, they are accepting an effective interest rate lower than the stated rate.
In subsequent periods, over the term of the bond, the premium or discount is "amortized" down towards zero. The main principle applied is that interest expense is recorded in each period as the product of the book value of the bond times the effective interest rate.
An amortization table is useful to prepare upfront, and can be entirely determined using the terms of the bond contract and the purchase price of the bond (or equivalently in the proceeds yielded from its sale). The nominal interest rate is stated in the bond contract; the effective interest rate is the internal rate of return that is implicit in the cash flows (upfront yield of bond proceeds, vs. future nominal interest payments and payment of the face value of the bond at maturity). The internal rate of return can be found by trial and error, or it can easily be calculated in software such as Excel spreadsheet software's Internal Rate of Return formula.
For a 2,000,000 face value 10 year bond with 10% annual interest, with interest paid semiannually, sold at a premium, yielding $2,080,000, the amortization table is as follows:
Cash Effective Amortization of Balance payments interest premium outstanding Period (or carrying value) 0 1 2 3
When the results will not be materially different, it is allowable to use a straight-line approach to amortize the premium or discount, and accordingly to set what is the interest expense that is recorded. The accounting principle involved is that of materiality.
The corresponding amortization table for the same bond, but now using
Cash Effective Amortization of Balance payments interest premium outstanding Period (or carrying value) 0 2,080,000 1 100,000 96,000 4,000 2,076,000 2 100,000 96,000 4,000 2,072,000 3 100,000 96,000 4,000 2,068,000 ... ... ... ... ... 20 100,000 96,000 4,000 2,000,000
Note: where effective interest rate is more different from stated interest rate (or, equivalently, where bond proceeds are significantly different from face value of the bond), the effective interest rate method provides a materially better analysis.
Debt issue costs
A small complication is needed to treat the various administrative costs of a bond issuance, which reduce its overall yield of proceeds for the firm. For exammple, consider a bond issue where $60,000 of printing, legal, and other administrative costs are incurred, where the face value is $10,000,000 bond, and total proceeds collected are $10,020,000.
Under U.S. GAAP accounting, oddly, the debt issue costs of $40,000 are recorded as an asset. The overall cash proceeds received is not reported as that, but rather the cash collected less the debt issue cost is reported as increasing the firm's cash account.
Debt issue costs $60,000 Cash $9,960,000 Bond payable $10,000,000 Premium on bond 20,000
In future periods, the debt issue cost is expensed off over the period of the bond. For example, with straigthline amortization over 10 years, each year would show:
Debt issue expense $6,000 Debt issue cost $6,000 Interest expense $x-2,000 Premium on bond $2,000 Interest payable $x
Under IFRS accounting, the accounting is done more naturally. However, if the same straightline methods are used, the totals expensed each year are the same.
Most purchases made for services or supplies are made on open accounts. The obligations that arise from these purchases are known as accounts payable. Purchases made on open account generally have a short-term payment period, are non-interest bearing, and are reported at face-value (time value of money is ignored). Unlike most other payables, the only formal agreement between companies related to purchases on account is the purchase invoice.
Trade Notes Payable
Trade notes issued for merchandise purchases that are not made on open account. Unlike accounts payable, trade notes are characterized by longer terms and written promissory notes.
When deposits are collected in advance from customers and expected to be returned at a future date, a liability for the deposit must be created. A debit is made to cash, with a credit to the corresponding liability account. When the deposit is returned, the entry is reversed. If any part of the deposit is forfeited, the forfeited amount is credited to revenue. If the deposit was made on, for example, a piece of equipment that was rented and not returned, along with the credit to revenue upon forfeiture, a second entry would be made to account for the decrease in inventory and cost of goods sold.
Self-Study Question: Happy Productions, Inc. rents chairs to the public for parties and special events. Upon rental, they require a $10 deposit per chair, which is twice of Happy Production’s cost to purchase the chairs. Deposits are forfeited if the chairs are not returned at the end of the rental period. A recent customer rented 50 chairs, but only returned 90% of the chairs at the end of the rental period. What is the amount of revenue that Happy would recognize at the end of the rental agreement? What would be the amount of Happy’s reduction to inventory? Answer: Revenue-$50 Inventory-$25
Advances from customers
Advances are payments from customers before goods are delivered or services rendered, for example magazine subscriptions. The funds collected in advance will be applied to the purchase price, and are considered liabilities until the earnings process is complete.
Provisions for warranties
- For expanded treatment, see Intermediate Accounting/Accounting for Income Taxes
In many countries, accounting for tax purposes is the same as accounting for financial reporting. However, the purposes of tax laws often diverge from the purposes of GAAP financial reporting. For example, a tax law may allow for accelerated depreciation of new capital equipment, which makes firms' new purchases less expensive in real terms. This is one way to implement a nation's economic policy of promoting new investment and perhaps full employment. Extremely accelerated depreciation goes against the matching principle in accounting, however. By the matching principle, the costs of use of the equipment should be matched to the time periods in which the benefits of use are enjoyed.
In the United States, specifically, accounting for income taxes is complicated by differences between GAAP accounting for financial reporting versus tax accounting for U.S. IRS tax forms.
There are "permanent differences" which are relatively easy to account for. For example, a firm may invest in a tax-free municipal bond, and its total GAAP earnings would reflect interest income that is deductible from the firm's taxable income reported on its tax returns. If the firm's GAAP tax expense is computed simplistically as the firm's GAAP earnings times its marginal income rate, that would yield an incorrect, higher value for its tax expense. The firm's actual income tax rate is lower.
The temporary differences are more complicated to account for. They give rise to "deferred tax liabilities" and "deferred tax assets". These are accounts needed to track the timing differences between recognition of expenses and revenues for GAAP books vs. for tax books, for events that have already occurred. Most firms of any size have multiple" specific differences which need to be tracked. There are four general types:
1.) "GAAP-first revenues" is a shorthand term (coined here, not a widely used term) which describes cases where firms' GAAP accounting recognizes revenues before those revenues appear in taxable income. Installment sales is a prime example. Under GAAP accounting, the revenue associated with a sale of land or property is recorded when a firm contract is reached and the new owner takes possession of the property. So all the earnings related to a sale of land that will be paid for by installments over several years, may be recognized at the time of sale. But by U.S. IRS tax accounting, the revenue is not recognized until it is collected.
2.) "Tax return-first revenues" is a shorthand term (coined here) for cases where firms' taxable income shows revenues that are not yet recognized in GAAP accounting. The IRS counts as taxable income the advance collections of rent and other advance collections. Under GAAP accounting those collections are recorded first as unearned revenues, which are only recognized as revenues when the service or product are delivered.
3.) "GAAP-first expenses" include estimated expenses, such as bad debt expense which is recognized along with setting up a general allowance for bad debts (a.k.a. an allowance for uncollectible receivables). Tax accounting does not recognize bad debts until the specific customer accounts are written off.
4.) "Tax return-first expenses" include MACRS accelerated depreciation.
Categorization as short- vs. long-term liabilities
On the GAAP balance sheet, balances of deferred tax assets and liabilities conceivably could be reported in four places: under Current Assets, Current Liabilities, Long-term Assets, and Long-term Liabilities. GAAP allows, however, for short-term DTA to be offset by short-term DTL, and the same for longterm DTA and DTL, so the balance sheet in fact shows just one DTA or DTL in the current section, reported at net, and shows similarly just one net position in the long-term section.
There are two types of pension plans, the defined contribution plan and the defined benefit plan.
defined contribution pension plan
The defined contribution pension plan promises fixed annual contributions to a pension fund by the employer. The employee chooses where funds are invested. The retirement benefit is determined by the amount accumulated in the pension account upon retirement (Spiceland).
defined benefit pension plan
The defined benefit pension plan promises fixed retirement benefits “defined” by a pension formula. The pension is normally based on the employees’ years of service and annual compensation. The employer is responsible for paying promised benefits (Spiceland).
Questions for self-study
Provisions for court decisions
To learn about contingent liabilities we will first explore disclosure notes found on recent 10K filings from three well known corporations. We will then learn the Accounting Standards Codification and SFAS references regarding contingent liabilities. Next, we will learn why the corporations recorded their contingencies as they did as it relates to the Accounting Standards Codification. Finally, we will further explore contingent liabilities by working through some various problems. Various references are used from an Intermediate Accounting Textbook (Spiceland, David, James Sepe, Mark Nelson, and Lawrence Tomassini. Intermediate Accounting. Fifth Edition. Volume Two. New York, NY: Mc-Graw-Hill/Irwin, 2009. Pages 665-697. Print.)
1. Verizon Communications Inc; December 31, 2009; Note 17 - Commitments and Contingencies “Several state and federal regulatory proceedings may require our telephone operations to pay penalties or to refund to customers a portion of the revenues collected in the current and prior periods. There are also various legal actions pending to which we are a party and claims which, if asserted, may lead to other legal actions. We have established reserves for specific liabilities in connection with regulatory and legal actions, including environmental matters that we currently deem to be probable and estimable. We do not expect that the ultimate resolution of pending regulatory and legal matters in future periods, including the Hicksville matter described below, will have a material effect on our financial condition, but it could have a material effect on our results of operations for a given reporting period.”
“During 2003, under a government-approved plan, remediation commenced at the site of a former Sylvania facility in Hicksville, New York that processed nuclear fuel rods in the 1950s and 1960s. Remediation beyond original expectations proved to be necessary and a reassessment of the anticipated remediation costs was conducted. A reassessment of costs related to remediation efforts at several other former facilities was also undertaken. In September 2005, the Army Corps of Engineers (ACE) accepted the Hicksville site into the Formerly Utilized Sites Remedial Action Program. This may result in the ACE performing some or all of the remediation effort for the Hicksville site with a corresponding decrease in costs to Verizon. To the extent that the ACE assumes responsibility for remedial work at the Hicksville site, an adjustment to a reserve previously established for the remediation may be made. Adjustments to the reserve may also be made based upon actual conditions discovered during the remediation at this or any other site requiring remediation.”
The above contingencies are related to litigation claims against Verizon Communications. The first two sentences, “Several state and federal regulatory proceedings may require our telephone operations to pay penalties or to refund to customers a portion of the revenues collected in the current and prior periods,” are related to claims the organizations in this industry find throughout their course of business. The second portion of this contingency relates to various legal actions pending. These items are not accrued because these are either litigation claims or the likelihood is not probable and the amount cannot reasonably be estimated. From chapter 13 (Spiceland, David, James Sepe, Mark Nelson, and Lawrence Tomassini. Intermediate Accounting. Fifth Edition. Volume Two. New York, NY: Mc-Graw-Hill/Irwin, 2009. Pages 665-697. Print.), “A loss contingency is accrued only if a loss is probable and the amount can reasonably be estimated.” Later in chapter 13 we learn, “the majority of medium and large corporations annually report loss contingencies due to litigation. In practice, accrual of a loss from pending or ongoing litigation is rare.” With this in mind, we know that the events stated in the contingency notes form Verizon should not be accrued and listed only as a disclosure note.
2. Dell Inc; January 29, 2010; Note 9 – Commitments and Contingencies
Legal Matters — Dell is involved in various claims, suits, assessments, investigations, and legal proceedings that arise from time to time in the ordinary course of its business, including matters involving consumer, antitrust, tax, intellectual property, and other issues on a global basis. While Dell does not expect that the ultimate outcomes in these proceedings, individually or collectively, will have a material adverse effect on its business, financial position, results of operations, or cash flows, the results and timing of the ultimate resolutions of these various proceedings are inherently unpredictable. Whether the outcome of any claim, suit, assessment, investigation, or legal proceeding, individually or collectively, could have a material effect on Dell’s business, financial condition, results of operations, or cash flows, will depend on a number of variables, including the nature, timing, and amount of any associated expenses, amounts paid in settlement, damages or other remedies or consequences. Dell accrues a liability when it believes that it is both probable that a liability has been incurred and that it can reasonably estimate the amount of the loss. Dell reviews these accruals at least quarterly and adjusts them to reflect ongoing negotiations, settlements, rulings, advice of legal counsel, and other relevant information. To the extent new information is obtained and Dell’s views on the probable outcomes of claims, suits, assessments, investigations, or legal proceedings change, changes in Dell’s accrued liabilities would be recorded in the period in which such determination is made. The following is a discussion of Dell’s significant on-going legal matters and other proceedings: Investigations and Related Litigation — In August 2005, the SEC initiated an inquiry into certain of Dell’s accounting and financial reporting matters and requested that Dell provide certain documents. The SEC expanded that inquiry in June 2006 and entered a formal order of investigation in October 2006. In August 2006, because of potential issues identified in the course of responding to the SEC’s requests for information, Dell’s Audit Committee, on the recommendation of management and in consultation with PricewaterhouseCoopers LLP, Dell’s independent registered public accounting firm, initiated an independent investigation, which was completed in the third quarter of Fiscal 2008. Although the Audit Committee investigation has been completed, the SEC investigation is ongoing. Dell continues to cooperate with the SEC investigation. Dell and the SEC staff have had preliminary discussions about a potential settlement of the matter. Thus far, an agreement has not been reached. Dell believes that any resolution would likely include monetary penalties, which cannot be quantified at this time, and other relief within the SEC’s authority. Discussions with the SEC staff are ongoing, and no assurance can be given as to the ultimate outcome of this matter, including the terms and conditions of any settlement. Dell and several of its current and former directors and officers were named as parties to the following outstanding securities and shareholder derivative lawsuits all arising out of the same events and facts.
— Four putative securities class actions filed between September 13, 2006, and January 31, 2007, in the Western District of Texas, Austin Division, against Dell and certain of its current and former officers were consolidated as In re Dell Securities Litigation, and a lead plaintiff was appointed by the court. The lead plaintiff asserted claims under sections 10(b), 20(a), and 20A of the Securities Exchange Act of 1934 based on alleged false and misleading disclosures or omissions regarding Dell’s financial statements, governmental investigations, internal controls, known battery problems and business model, and based on insiders’ sales of Dell securities. This action also included Dell’s independent registered public accounting firm, PricewaterhouseCoopers LLP, as a defendant. On October 6, 2008, the court dismissed all of the plaintiff’s claims with prejudice and without leave to amend. On November 3, 2008, the plaintiff appealed the dismissal of Dell and the officer defendants to the Fifth Circuit Court of Appeals. The appeal was fully briefed, and oral argument on the appeal was heard by the Fifth Circuit Court of Appeals on September 1, 2009. On November 20, 2009, the parties to the appeal entered into a written settlement agreement whereby Dell would pay $40 million to the proposed class and the plaintiff would dismiss the pending litigation. The settlement was preliminarily approved by the district court on December 21, 2009. The settlement is subject to certain conditions, including opt-outs from the proposed class not exceeding a specified percentage and final approval by the district court. Until these conditions to the settlement have been satisfied, there can be no assurance that the settlement will become final. If the settlement does not become final, Dell will continue its defense of the appeal before the Fifth Circuit. Therefore, as of January 29, 2010, Dell has not accrued a liability for these class actions.
—In addition, seven shareholder derivative lawsuits filed between September 29, 2006, and January 22, 2007, in three separate jurisdictions were consolidated as In re Dell Derivative Litigation into three actions. One of those consolidated actions was pending in the Western District of Texas, Austin Division, but was dismissed without prejudice by an order filed October 9, 2007. The second consolidated shareholder derivative action was pending in Delaware Chancery Court. On October 16, 2008, the Delaware court granted the parties’ stipulation to dismiss all of the plaintiffs’ claims in the Delaware lawsuit without prejudice. The third consolidated shareholder derivative action was pending in state district court in Williamson County, Texas. These shareholder derivative lawsuits named various current and former officers and directors as defendants and Dell as a nominal defendant and asserted various claims derivatively on behalf of Dell under state law, including breaches of fiduciary duties. On September 11, 2009, Dell entered into an agreement to settle the derivative suit pending in state district court in Williamson County, Texas, and the previously reported shareholder demand letter dated November 12, 2008, asserting allegations similar to those made in these lawsuits. The settlement received final approval by the court on December 15, 2009. The settlement required Dell to initiate and maintain certain corporate governance changes and provided for the payment of approximately $1.75 million in fees to the plaintiffs’ counsel.
Ironically, on July 22, 2010 this information came from Washington, D.C.:(http://www.sec.gov/news/press/2010/2010-131.htm) SEC Charges Dell and Senior Executives with Disclosure and Accounting Fraud Company to Pay $100 Million Penalty, Michael Dell to Pay $4 Million Penalty FOR IMMEDIATE RELEASE 2010-131 Washington, D.C., July 22, 2010 — The Securities and Exchange Commission today charged Dell Inc. with failing to disclose material information to investors and using fraudulent accounting to make it falsely appear that the company was consistently meeting Wall Street earnings targets and reducing its operating expenses.
The first paragraph titled, “Legal Matter,” explains the policies Dell employs regarding the various legal matters that it finds throughout the course of their business. As we move further into the disclosure note we find a specific legal matter that Dell is currently involved in. In August 2005, the SEC initiated a concern regarding some of Dell’s accounting and financial reporting. This matter started an internal investigation between internal Dell auditors and an independent auditing firm. This investigation was completed in 2008. At the time of this disclosure there was still an ongoing SEC investigation and is sitting in the court system pending a final approval for a possible settlement amount to be paid. The second bullet within this case is regarding Dell Derivative Litigation, which was divided into three separate actions. The first two actions were dismissed without prejudice. The third action was settled and approved by the courts. This settlement required Dell to initiate and maintain certain corporate governance changes and pay $1.75 million in fees to the plaintiff’s council. This final action should be accrued because, as Dell put it, “the liability has been incurred and that it can reasonably estimate the amount of the loss.”
The initial investigation spurred by the SEC is not accrued because it is not settled and the penalty amount is not known. Also, as discussed in Intermediate Accounting (Spiceland, David, James Sepe, Mark Nelson, and Lawrence Tomassini. Intermediate Accounting. Fifth Edition. Volume Two. New York, NY: Mc-Graw-Hill/Irwin, 2009. Pages 665-697. Print.) textbook, if an amount was to be accrued before the case is settled in court, this accrual “would be welcome ammunition for the opposing legal counsel.”
3. Best Buy Co. Inc. February 27, 2010; 13. Contingencies and Commitments Contingencies “In December 2005, a purported class action lawsuit captioned, Jasmen Holloway, et al. v. Best Buy Co., Inc., was filed in the U.S. District Court for the Northern District of California alleging we discriminate against women and minority individuals on the basis of gender, race, color and/or national origin with respect to our employment policies and practices. The action seeks an end to discriminatory policies and practices, an award of back and front pay, punitive damages and injunctive relief, including rightful place relief for all class members. At February 27, 2010, no accrual had been established as it was not possible to estimate the possible loss or range of loss because this matter had not advanced to a stage where we could make any such estimate. A class certification hearing was held in June 2009, and we await the Court's decision. We believe the allegations are without merit and intend to defend this action vigorously. We are involved in various other legal proceedings arising in the normal course of conducting business. We believe the amounts provided in our consolidated financial statements, as prescribed by GAAP, are adequate in light of the probable and estimable liabilities. The resolution of those other proceedings is not expected to have a material impact on our results of operations or financial condition.” The initial paragraph is explaining a pending class action lawsuit against Best Buy on the basis on employment discrimination. This situation has not been accrued because it is a pending lawsuit; therefore Best Buy cannot determine if it is neither probable nor the amount of money to be paid out. Also, again, pending court matters are not accrued until a court decision has been determined and finalized.
FASB Accounting Standards Codification: The above examples of contingencies from Verizon, Dell, and Best Buy demonstrate litigation claims. These organizations list the general policies the organization employs to handle these situations and also gives specific information regarding specific cases it is currently dealing with. FASB Accounting Standards Codification provides us with the below guidance when dealing with such contingencies (information below to SFAS No. 5 is from FASB Accounting Standards Codification):
(Code: 450 Contingencies: 20 Loss Contingencies: 25 Recognition) Provides general rules when dealing loss contingencies. General Rule 25-1When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. As indicated in the definition of contingency, the term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses. The Contingencies Topic uses the terms probable, reasonably possible, and remote to identify three areas within that range. 25-2 An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: • a. Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. • b. The amount of loss can be reasonably estimated. The purpose of those conditions is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period. Paragraphs 450-20-55-1 through 55-17 and Examples 1–2 (see paragraphs 450-20-55-18 through 55-35) illustrate the application of the conditions. As discussed in paragraph 450-20-50-5, disclosure is preferable to accrual when a reasonable estimate of loss cannot be made. Further, even losses that are reasonably estimable shall not be accrued if it is not probable that an asset has been impaired or a liability has been incurred at the date of an entity's financial statements because those losses relate to a future period rather than the current or a prior period. Attribution of a loss to events or activities of the current or prior periods is an element of asset impairment or liability incurrence.
(Code: 450 Contingencies: 20 Loss contingencies: 55 Implementation Guidance and Illustrations) Deals specifically with litigation and provides an example with the appropriate footnote.
> >Litigation, Claims, and Assessments 55-10The following factors should be considered in determining whether accrual and/or disclosure is required with respect to pending or threatened litigation and actual or possible claims and assessments: • a. The period in which the underlying cause (that is, the cause for action) of the pending or threatened litigation or of the actual or possible claim or assessment occurred • b. The degree of probability of an unfavorable outcome • c. The ability to make a reasonable estimate of the amount of loss. Examples 1 through 2 (see paragraphs 450-20-55-18 through 55-35) illustrate the consideration of these factors in determining whether to accrue or disclose litigation.
55-18 An entity may be litigating a dispute with another party. In preparation for the trial, it may determine that, based on recent developments involving one aspect of the litigation, it is probable that it will have to pay $2 million to settle the litigation. Another aspect of the litigation may, however, be open to considerable interpretation, and depending on the interpretation by the court the entity may have to pay an additional $8 million over and above the $2 million. 55-19 In that case, paragraph 450-20-25-2 requires accrual of the $2 million if that is considered a reasonable estimate of the loss. 55-20 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the accrual,and depending on the circumstances, may require disclosure of the $2 million that was accrued. 55-21 Paragraphs 450-20-50-3 through 50-8 require disclosure of the additional exposure to loss if there is a reasonable possibility that the additional amounts will be paid.
> > Example 2: Multiple Case Litigation Example 55-22 The following Cases illustrate application of the accrual and disclosure requirements in the following stages of litigation: a. The trial is complete but the damages are undetermined (Case A). b. The trial is incomplete but an unfavorable outcome is probable (Case B). c. The trial is incomplete and unfavorable outcome is reasonably possible (Case C). d. There is a range of loss and one amount is a better estimate than any other (Case D).
> > > Case A: Trial Is Complete but Damages Are Undetermined 55-23 An entity is involved in litigation at the close of its fiscal year and information available indicates that an unfavorable outcome is probable. Subsequently, after a trial on the issues, a verdict unfavorable to the entity is handed down, but the amount of damages remains unresolved at the time the financial statements are issued or are available to be issued (as discussed in Section 855-10-25). Although the entity is unable to estimate the exact amount of loss, its reasonable estimate at the time is that the judgment will be for not less than $3 million or more than $9 million. No amount in that range appears at the time to be a better estimate than any other amount. 55-24 In this Case, paragraph 450-20-30-1 requires accrual of the $3 million (the minimum of the range) at the close of the fiscal year. 55-25 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the contingency and, depending on the circumstances, may require disclosure of the amount of the accrual. 55-26 Paragraphs 450-20-50-3 through 50-8 require disclosure of the exposure to an additional amount of loss of up to $6 million.
> > >Case B: Trial Is Incomplete but Unfavorable Outcome Is Probable 55-27 Assume the same facts as in Case A, except it is probable that a verdict will be unfavorable and the trial has not been completed before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25). In that situation, the condition in paragraph 450-20-25-2(a) would be met because information available to the entity indicates that an unfavorable verdict is probable. An assessment that the range of loss is between $3 million and $9 million would meet the condition in paragraph 450-20-25-2(b). 55-28 In this Case, if no single amount in that range is a better estimate than any other amount, paragraph 450-20-30-1 requires accrual of $3 million (the minimum of the range) at the close of the fiscal year. 55-29 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the contingency and, depending on the circumstances, may require disclosure of the amount of the accrual. 55-30 Paragraphs 450-20-50-3 through 50-8 require disclosure of the exposure to an additional amount of loss of up to $6 million.
> > >Case C: Trial Is Incomplete and Unfavorable Outcome Is Reasonably Possible 55-31 Assume the same facts as in Case B, except the entity had assessed the verdict differently (for example, that an unfavorable verdict was not probable but was only reasonably possible). The condition in paragraph 450-20-25-2(a) would not have been met and no amount of loss would be accrued. Paragraphs 450-20-50-3 through 50-8 require disclosure of the nature of the contingency and any amount of loss that is reasonably possible.
> > >Case D: Range of Loss and One Amount Is a Better Estimate than Any Other 55-32 Assume that in Case A and Case B the condition in paragraph 450-20-25-2(a) has been met and a reasonable estimate of loss is a range between $3 million and $9 million but a loss of $4 million is a better estimate than any other amount in that range. 55-33 In this Case, paragraph 450-20-30-1 requires accrual of $4 million. 55-34 Paragraphs 450-20-50-1 through 50-2 require disclosure of the nature of the contingency and, depending on the circumstances, may require disclosure of the amount of the accrual. 55-35 Paragraphs 450-20-50-3 through 50-8 require disclosure of the exposure to an additional amount of loss of up to $5 million.
> >Example 3: Illustrative Disclosure 55-36 Entity A is the defendant in litigation involving a major competitor claiming patent infringement (Entity B). The suit claims damages of $200 million. Discovery has been completed, and Entity A is engaged in settlement discussions with the plaintiff. Entity A has made an offer of $5 million to settle the case, which offer was rejected by the plaintiff; the plaintiff has made an offer of $35 million to settle the case, which offer was rejected by Entity A. Based on the expressed willingness of the plaintiff to settle the case along with information revealed during discovery and the likely cost and risk to both sides of litigating, Entity A believes that it is probable the case will not come to trial. Accordingly, Entity A has determined that it is probable that it has some liability. Entity A's reasonable estimate of this liability is a range between $10 million and $35 million, with no amount within that range a better estimate than any other amount; accordingly, $10 million was accrued. 55-37 Entity A provides the following disclosure in accordance with Section 450-20-50. •On March 15, 19X1, Entity B filed a suit against the company claiming patent infringement. While the company believes it has meritorious defenses against the suit, the ultimate resolution of the matter, which is expected to occur within one year, could result in a loss of up to $25 million in excess of the amount accrued.
SFAS No. 5 (Found in the text on page 672) “If the failure to disclose the possible loss would cause the financial statements to be misleading, the situation should be described in a disclosure note, including the effect of the possible loss on key accounting numbers affected.” (“‘Accounting for Contingencies’, Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 11. ~As stated by SFAS No. 5, disclosure notes allow an organization to communicate a possible change or future affect in relation to past situation where the outcome is still pending. This allows investors and/or creditors to be aware of what the internal organization is aware without accruing the possible outcome.
Relating Accounting Standards Codification to our three corporate examples: Verizon Communications Inc. The Hicksville matter seems to align with “Case A” (450:20:55:23) which reads: Case A: Trial Is Complete but Damages Are Undetermined 55-23 An entity is involved in litigation at the close of its fiscal year and information available indicates that an unfavorable outcome is probable. Subsequently, after a trial on the issues, a verdict unfavorable to the entity is handed down, but the amount of damages remains unresolved at the time the financial statements are issued or are available to be issued (as discussed in Section 855-10-25). Although the entity is unable to estimate the exact amount of loss, its reasonable estimate at the time is that the judgment will be for not less than $3 million or more than $9 million. No amount in that range appears at the time to be a better estimate than any other amount. I decided this situation is most like Case A because of the following information that was provided in the disclosure note: “To the extent that the ACE assumes responsibility for remedial work at the Hicksville site, an adjustment to a reserve previously established for the remediation may be made. Adjustments to the reserve may also be made based upon actual conditions discovered during the remediation at this or any other site requiring remediation.” This statement implies that the decision has been made that Verizon is liable for the damages; however, the amount of total damages will be decided as cleanup continues. Assuming this is the case Verizon Communications recorded this incident correctly and no accrual is needed.
Dell Inc. Dell’s situation is similar to Verizon’s in that nothing has been settled. The court has not made a decision on this matter; however, we do have a settlement amount that has not been finalized. I was thinking this could be Case A because there is an amount discussed. However, Case A implies that the case is settled but there is not a set amount to be paid. With this in mind Dell falls into Case B as an unfavorable outcome is probable, a disclosure note is needed because the amount cannot be determined at the time of the financial statements. If we are considering the 2010 financial statements an accrual would be required because the case is finalized with a bill of $100 million to Dell.
Best Buy Co. Inc. The discrimination in employment suit is going to be a Case C because we cannot determine much of anything at this point regarding the probability or the amount. However, this is a pending case so we need a disclosure note as Best Buy has done.
1. Referring to the Dell case and more particularly the recent news from July 22, 2010, what would change on the 2010 financial statements? (Provide needed journal entries and/or disclosure notes).
2. Read the disclosure note below. This contingency seems probable and the amount seems to have a reasonable estimate, why does Dell not accrue the contingency? “On November 20, 2009, the parties to the appeal entered into a written settlement agreement whereby Dell would pay $40 million to the proposed class and the plaintiff would dismiss the pending litigation. The settlement was preliminarily approved by the district court on December 21, 2009, (Dell financial statements 2009)”
3. For the following example record the required journal entry and/or disclosure not. Explain your reasoning by citing the Accounting Standards Codification above.
During the fiscal year 2009, XYZ Corporation is facing a class action lawsuit because a trinket they designed, manufactured, and sold malfunctioned and caused bodily harm to customers. Towards the end of the fiscal year the court handed down an unfavorable verdict against XYZ Corporation. The total amount of the damages has not been resolved at the time of the financial statement issuance. XYZ Corporation, though does not have an exact amount, reasonably estimates damages to be between 10 and 15 million dollars.
4. Working off the same situation for XYZ Corporation as in question 3. Before the financial statements are released we have an update for the total damages. The corporation has found that $12 million is the best estimate of total damages (though not known for sure). How does this change our journal entry and/or disclosure note?
5. In an unsettled court case why would you not accrue an anticipated loss even if it is probable and the amount can be reasonably estimated?
6. ABC Corp is charged with a pending lawsuit. The amount nor the probability of damages is known. How should ABC Corp disclose this information to investors and creditors?
7. Why, if an expense has not accrued, is it important to tell investors or creditors about future obligations that might occur?
1. Loss-litigation(Debt).........................$100 Million Liability-litigation(Credit)...............................$100 Million A disclosure note is also appropriate explaining the cause of the loss, ongoing litigation, and the recent court decision.
2. Dell would not accrue this contingency because it is still not finalized. As we realized in 2010, this $40 Million turned into $100 Million.
3. Loss Contingency-Litigation(Debt)..................$10 Million Liability(Credit)............................................$10 Million Reference Case A (55-23) above as it states that a case where the trial is complete but damages are undetermined we would record an accrual for $10 million, the minimum in the range.
4. Loss Contingency-Litigation.............$12 Million Liability-Litigation.................................$12 Million In questions 3 and 4, refer to Case A (55-23) where additional disclosure would be required for the potential range of the loss.
5. In an unsettled court case we would not accrue an anticipated loss because, as stated earlier, the fact that the corporation accrued this amount can be used as evidence for the other side in the court room. When it comes to a jury decision, a corporation already anticipating a loss makes it easier for the jury to issue damages to the corporation.
6. On July 3rd, 2008 ABC Corp was served with a lawsuit regarding the waste they left on a previous site. On February 27, 2009 no accrual has been established because it is not possible to estimate the possibility of loss nor the amount of loss. This lawsuit is not at a point where we could make an estimate. (This case is very similar to the Best Buy case above).
7. It is important to provide full-disclosure in all financial reporting, as explained in SFAS No. 5. SFAS No. 5 explains, "“If the failure to disclose the possible loss would cause the financial statements to be misleading, the situation should be described in a disclosure note, including the effect of the possible loss on key accounting numbers affected.”
Leases A lease is a contractual arrangement by which a lessor/owner provides a lessee/user the right to use an asset for a specified period of time. In return, the lessee agrees to make periodic cash payments during the term of the lease. An apartment lease is a typical rental agreement referred to as an operating lease in which the fundamental rights and responsibilities of ownership are retained by the lessor. Capital leases(Direct financing or sales-type leases to the lessor) are contracts that are formulated outwardly as leases, but in reality are installment purchases/sales. Typically, Lessee: 1. Operating Lease 2. Capital Lessor: 1.Operating Lease 2. Direct Financing Lease or Sales-type lease Leasing sometimes is used as a means of off-balance-sheet financing. Operational, tax, and financial market incentives often make leasing an attractive alternative to purchasing.
Lease Classification Capital Leases: A lessee should classify a lease transaction as a capital lease if it includes a noncancelable lease term and one or more of the four criteria listed are met. Otherwise, it is an operating lease. 1. The agreement specifies that ownership of the asset transfers to the lessee. 2. The agreement contains a bargain purchase option. 3. The noncancelable lease term is equal to 75% or more of the expected economic life of the asset. 4. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.
A Bargain purchase option (BPO) is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a bargain price. This is defined as a price sufficiently lower than the expected fair value of the property that the exercise of the option appears reasonably assured at the inception of the lease.
Expected economic life: If an asset is leased for most of its useful life, then most of the benefits and responsibilities of ownership are transferred to the lessee. 75% or more of the expected economic life of the asset is threshold point for this purpose.
Bargain renewal options gives the lessee the option to renew the lease at a bargain rate. That is, the rental payment is sufficiently lower than the expected fair rental of the property at the date the option becomes exercisable that exercise of the option appears reasonably assured.
Minimum lease payments: If the lease payments required by a lease contract substantially pay for a leased asset, it is logical to identify the arrangement as a lease contract substantially pay for a leased asset, it is logical to identify the arrangement as a lease equivalent to an installment purchase. It is considered to exist when the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset at the inception of the lease. Additional Lessor Conditions 1. The collectibility of the lease payments must be reasonably predictable. 2. If any costs to the lessor have yet to be incurred, they are reasonably predictable. (Performance by the lessor is substantially complete.)
Operating Lease If a lease does not met any of the criteria for a capital lease it is considered to be more in the nature of a rental agreement and is referred to as an operating lease. In an operating lease, rent is recognized on a straight-line basis unless another systematic method more clearly reflects the benefits of the asset's use. So, if rental payments are uneven-for instance, if rent increases are scheduled-the total scheduled payments ordinarily would be expensed equally over the lease term. Advance Payments Often lease agreements call for advance payments to be made at the inception of the lease that represent prepaid rent. For instance, it is common for a lessee to pay a bonus in return for negotiating more favorable lease terms. Such payments are recorded as prepaid rent and allocated( normally on a straight-line basis ) to rent expense/rent revenue over the lease term. Sometimes advance payments include security deposits that are refundable at the expiration of the lease or prepayments of the last period's rent. Rent payments may be scheduled to increase periodically over the lease term. The total rent over the term of the lease is allocated to individual periods on a straight-line basis. As a result, the temporarily unpaid portion of rent expense must be credited to deferred rent expense payable until later in the lease term when rent payments exceed rent expense.
On January 1, 2010, Doogin Wagon, Inc., a computer services firm, leased a printer from ElernZac Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2010, the inception of the lease, and at each January 1 thereafter through 2013. The useful life of the printer is estimated to be eight years. Before deciding to lease, Doogin Wagon considered purchasing the printer for its cash price of $625,000. If funds were borrowed to buy the copier, the interest rate would have been 10%. 1. Does the agreement specify an ownership transfer? 2. Does the agreement contain a bargain purchase option? 3. Is the lease term equal to 75% or more of the expected economic life of the asset? 4. Is the present value of the minimum lease payments equal to or greater than 90% of the fair value of the printer? 5. How should this lease be classified?
ANSWER: 1. Does the agreement specify an ownership transfer? NO
2. Does the agreement contain a bargain purchase option? NO
3. Is the lease term equal to 75% or more of the expected economic life of the asset? 4 years < 75% of 8 years 4 years < 6 years NO
4. Is the present value of the minimum lease payments equal to or greater than 90% of the fair value of the printer? $100,000 x 3.48685 (Table 6, n=4, i=10%)= $348,685 $348,685 < 90% of $625,000=$348,685 < $562,500
5. How should this lease be classified? Since none of the four classification criteria is met, this is an operating lease.
Current U.S. GAAP accounting allows and requires that the award of stock options be expensed over the period of employee vesting, and that the total amount to be expensed must equal a valid estimate, upfront, of the value given away. Using various model-based approaches to estimating the value, as of award date, is acceptable.
Often stock options are issued using graded vesting, also known as "cliff vesting". When multiple tranches are issued at the same time, i.e. a stock option package is issued in which an employee vests portions at a time, various accounting approaches for averaging are allowed by U.S. GAAP. Simplest, conceptually, is to treat each tranche as a separate stock option. More complicated, in a way, is to value the entire package of stock options at a per-option value based on a weighted average of option lives, and then to straightline that. This usually yields a higher option value (and higher total compensation cost to be recognized), than the average of the individual options. But it also can significantly slow the recognition.
For example, p.1078 Spiceland v.6 example, involving package of options that vest 20%, 30%, 50% in three successive years.
However, straight-line approach is not allowed if the amount expensed lags behind the amount vested. Obviously the accounting should recognize cumulative expense at least as high as cumulative amount vested. If vesting pattern was front-loaded, i.e. vest 50%, 30%, 20%, then the straightline expensing would not be adequate to stay up with vesting pattern.
Open question: Would U.S. GAAP accounting allow for applying the vested amounts, when the cumulative vested would be higher than cumulative expense under straight-line method? (To be examined by considering ASC).