Download Wahlen_1e_IM_Ch09 (new window)

Chapter 9
Current Liabilities and Contingent Obligations
Objectives
After reading this chapter, you will be able to:
1.
2.
3.
4.
Explain the characteristics of a liability.
Describe the nature, classification, and valuation of current liabilities.
Identify, measure, and record current liabilities based on a contractual amount.
Understand and record current liabilities whose amounts are determined by operating
activities.
5. Identify and account for contingent obligations, including warranties and premiums.
6. Describe the presentation and disclosure of current liabilities and contingent obligations.
Lecture Outline
I.
Conceptual overview of liabilities
A. Definition includes three characteristics
1. Present obligation to be settled by a probable future transfer of assets or
services at a specified or determinable date
2. Company has little or no discretion to avoid future sacrifice
3. Transaction or event obligating company already occurred
B. Key terms
1. Probable
2. Obligations
C. Types
1. Legal liabilities
2. Equitable and constructive liabilities
II. Current liabilities
A. Obligations a company must meet within one year or the normal operating cycle,
whichever is longer
B. Liquidity – how quickly a company can convert its assets to cash in order to cover
operating costs and pay liabilities when they become due
1. Current ratio
2. Quick ratio
C. Financial flexibility – company’s ability to use financial resources to adapt to change
and take advantage of opportunities
D. Classification
1. Contractual amounts
2. Amounts determined by operating activities
3.
Contingent amounts
III. Valuation of current liabilities
A. Present value of required future payment is conceptually preferred
B. In practice reported at maturity or face amount
1. Differences between two amounts not normally material
IV. Current liabilities based on a contractual amount
A. Trade accounts payable
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 2
1. Obligations to suppliers
a. Short credit period – record at face value
2. Record liabilities in period where economic control (transfer of title) has
passed from supplier
3. When cash discounts are offered can record using gross price method or net
price method
B. Notes payable
1. Promissory note requires borrower to repay a sum of money on a specific
date
2. Interest-bearing
a. Principal amount equals face value and interest rate stated explicitly
3. Non-interest-bearing
a. Interest is implied in the face value of the note – discount on notes
payable
b. Note is initially recorded at present value – face value minus discount
c. The discount is amortized and interest expense is reflected
d. Effective interest rate (APR)
4. Other short-term financing
a. Line of credit – allows borrowing from bank up to prearranged limit
5. Commercial paper – unsecured note payable
C. Currently maturing portion of long-term debt
1. Any long-term debt becomes a current liability immediately before the year
of retirement
2. Payments due in the following year on installment debt instruments
3. Obligations callable by the creditor if company violates long-term debt
agreement
D. Short-term debt expected to be refinanced
1. Exclude from current liability if company has intent and ability to refinance on
a long-term basis
E. Dividends payable
1. Current liability recorded on date dividend declared and eliminated on
payment date
2. Exceptions to current liability treatment
a. Stock dividend treated as an element of shareholders’ equity
b. Undeclared dividends in arrears on cumulative preferred stock
disclosed in notes to financial statements
F. Advances and refundable deposits
1. Treat as a liability at time deposit received
a. Classification depends on length of time until deposit will be returned
G. Property taxes
1. Become a legal liability on date specified by lien
2. Estimate and accrue tax liability in equal monthly amounts for fiscal period of
taxing authority
H. Liabilities from unconditional purchase obligations
1. Generally not recorded unless delivery of item purchased takes place
2. Exception occurs when fixed purchase price exceeds current market price –
loss and liability recorded
V. Current liabilities with amounts determined by operating activities
A. Accrued liabilities are expenses incurred but not yet paid
1. Many treated as end of period adjusting entries and most are current liabilities
B. Liabilities related to compensation
1. Employee withholdings and payroll taxes
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 3
a. Anticipated employee income taxes payable to governmental units
b. FICA (O.A.S.D.I. and medicare) – social security taxes – employee
withholding and employer share
c. Unemployment insurance taxes – employer liability
i.
FUTA
ii.
State
2. Voluntary payroll deductions – made for convenience of employee (i.e.
group health insurance, union dues)
3. Compensated absences – vacation, holiday, illness, personal activities –
liability recognized if following conditions met
a. Obligation based on employee service already rendered
b. Obligation relates to rights that vest or accumulate
c. Payment of compensation is probable
d. Amount can be reasonably estimated
4. Bonus obligations – earnings based bonuses typically triggered if company
income meets certain minimum levels
a. Reported as current liability and expense in year earned
C. Sales and use taxes
1. Sales tax collected by seller for governmental authority on transfer of goods or
services to customers
2. Use tax paid by buyer to governmental authority on purchases that seller did
not collect tax
D. Income taxes
1. Income of corporations is subject to federal and potentially state, local, and
foreign taxes
E. Unearned (deferred) revenues
1. Amounts collected in advance but not yet earned because product or
service not yet provided
VI. Contingent obligations
A. GAAP defines as “an existing condition, situation, or set of circumstances involving
uncertainty as to a possible gain (a “gain contingency”) or loss (a “loss
contingency”) that will be resolved when a future event occurs or fails to occur
B. Loss contingencies
1. Categories of likelihood of occurrence of future event that will confirm the
loss:
a. Probable – future event is likely to occur
b. Reasonably possible – chance of future event occurring is more than
remote but less than likely
c. Remote – chance of future event occurring is slight
2. Accrue estimated loss and liability if
a. Loss is probable and
b. Amount of loss can be reasonably estimated
3. Disclose loss contingency in notes to statements if criteria for accrual not
satisfied and loss is reasonably possible
4. Some remote contingencies might also require disclosure
5. IFRS and U.S. GAAP differences for contingent obligations
a. Terminology – IFRS uses the term provision as equivalent of U.S. GAAP
term contingency
b. Recognition
i.
IFRS defines probable as “more likely than not” which is a lower
threshold for recognition
ii.
IFRS requires disclosure of gain contingencies
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 4
c. Measurement
i.
IFRS requires use of present value technique for reporting
amount of contingency
ii.
IFRS requires use of mid-point if range of estimates for
contingency exist
6. Pending litigation – accrue loss and related liability if
a. Cause of litigation occurred before date of financial statements
b. It is probable the outcome of the lawsuit will result in a loss
c. The amount of the loss can be reasonably estimated
C. Warranty obligations
1. Expense warranty accrual method – company recognizes estimated warranty
expense and contingent liability in period of sale
2. Sales warranty accrual method – sale of warranty is separate from sale of
product and accounted for separately
a. Revenue deferred from sale of warranty contract and recognized on
a straight-line basis over life of contract
b. Costs necessary to satisfy warranty expensed as incurred
3. Modified cash basis method – record warranty costs as expense in period
repairs made under warranty
a. Violates GAAP but allowed under following conditions
i.
Warranty period is relatively short
ii.
Not possible to reliably estimate warranty obligation
iii.
When results not materially different from expense warranty
accrual method or sales warranty accrual method
b. Only method acceptable for federal income tax purposes
D. Premium, coupon, and cash rebate obligations
1. Costs should be matched against revenue in period of sale
E. Gain contingencies
1. Usually not accrued – applies conservatism principle
2. May be disclosed in notes to financial statements
VII. Financial statement presentation of current liabilities and contingencies
A. Broad guidelines for presenting assets and liabilities
1. Implications for financial flexibility
2. General liquidity characteristics
3. Measurement attributes
B. Order within current liability section
1. Average length of maturity
2. According to amount (largest to smallest)
3. Order of liquidation preference
C. Disclosures in notes to financial statements
1. Any major issues affecting current liabilities
Synopsis
Conceptual Overview of Liabilities
In its Conceptual Framework, the FASB defined liabilities as the probable future sacrifices of
economic benefits arising from present obligations of a company to transfer assets or provide
services in the future as a result of past transactions or events. There are three characteristics of
a liability:
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities



Instructor’s Manual, p. 5
A present obligation that will be settled by the probable future transfer of assets or
services at a specified or determinable date.
The company has little or no discretion to avoid the future sacrifice of economic benefits.
The transaction or other event obligating the company has already happened.
The definition does not require a company to know the identity of the recipient nor is a legally
enforceable claim necessary. Probable refers to what can be expected or believed based on
available evidence or logic. Obligations refer to duties imposed legally or socially which one is
bound to by contract, promise, or moral responsibility.
Legal liabilities are incurred in transactions that are contractual and include accounts payable,
notes payable, taxes payable, and wages payable. Equitable or constructive liabilities include
obligations where there is no legal requirement to transfer assets but the transfer typically occurs
as part of the normal operations of a business. These include items such as liabilities to
employees for vacation pay or year-end bonuses.
Current Liabilities
Current liabilities are obligations a company must meet within one year or the normal operating
cycle, whichever is longer. The operating cycle is the time normally required to convert cash to
inventory to receivables and back to cash. The usual classification criteria is one year because
most companies have operating cycles less than one year.
Liquidity is a measure of how quickly a company can convert an asset into cash to cover
operating costs and pay its liabilities when they become due. The FASB has identified several
ratios, such as the current ratio, as providing useful information about liquidity to financial
statement users. The SEC requires companies to discuss liquidity in the 10-K. The AICPA Special
Committee on Financial Reporting supports MD&A disclosures of the internal and external
sources of liquidity and significant unused sources of liquid assets.
Financial flexibility is the ability of a company to use its financial resources to adapt to change
and to take advantage of opportunities. This involves the management of cash and other
resources to achieve financial advantages from both an offensive and defensive point of view.
It involves the potential to create new current and long-term liabilities, to restructure existing
debt, and to manage debt in other ways. More liquid companies generally have greater
financial flexibility.
Two useful ratios for assessing a company’s liquidity are the current ratio and the quick ratio. The
current ratio is calculated by dividing current assets by current liabilities. Financial statement
users prefer a current ratio greater than 1.0, but exceptionally large current ratios can be
perceived negatively.
The quick ratio is calculated by dividing quick assets by current liabilities. The quick ratio is a
more restrictive measure of liquidity as the quick assets include highly liquid assets and exclude
inventories and other current assets.
U.S. companies report current liabilities in the first section of liabilities on the balance sheet.
Three primary types of current liabilities exist: contractual amounts, amounts determined by
operating activities, and contingent amounts.
Relevant Examples and Exhibits

Exhibit 9.1 Types of Current Liabilities
Valuation of Current Liabilities
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 6
Conceptually, current liabilities should be recorded and reported at the present value of
required future payments. In practice most current liabilities are measured, recorded, and
reported at their maturity or face amount. Usually the difference between present value and
maturity value is not material due to the short time period involved.
Current Liabilities Based on a Contractual Amount
Accounts payable (or trade accounts payable) are obligations to suppliers arising from
purchasing inventory, supplies, or services on credit. A key concern is recording accounts
payable in the proper accounting period when shipments are in transit at year end. The
purchaser should record the asset and liability in the period when economic control of the
goods passes. When cash discounts are offered, the company can record the transaction using
either the gross price method or the net price method.
A note payable is a promissory note that requires the borrower to repay a sum of money on a
specific date. Notes payable normally result from purchasing goods or services on credit or
borrowing money. When a note is interest-bearing, the principal amount equals the face value
of the note and the interest rate is stated explicitly on the note. The liability is recorded at an
amount equal to the face value of the note and interest is accrued over the life of the note by
applying the stated interest rate to the face value.
When a note is non-interest-bearing, the note is stated at its maturity value that includes both
principal and interest. The borrower receives less than face value with the implied interest equal
to the difference between the face value and the cash received. This implicit interest is
recorded as a discount on notes payable. Interest expense is recorded over the life of the note
by amortizing the discount on notes payable.
The effective interest rate is referred to as the annual percentage rate (APR). The effective
interest rate can be calculated by dividing the total interest paid by the amount of cash
borrowed and multiplying by a time factor that represents the portion of a year the money is
borrowed.
A line of credit (or letter of credit) is an agreement that allows a corporation to borrow up to a
prearranged limit. This allows the corporation to borrow only what they need and pay interest
only on the money borrowed under the line of credit.
Commercial paper is an unsecured note payable that is commonly used to finance accounts
receivable and inventory, as well as to meet other short-term obligations. The maturities for
commercial paper usually range from 30 to 270 days.
Generally, a company classifies the currently maturing portion of long-term debt as a current
liability to show the effect on its liquidity. If a company violates a long-term debt agreement
and the liability becomes callable by the creditor within one year, the company reports the
entire amount of the long-term obligation as a current liability unless it meets one of the following
conditions:


The creditor has waived the right to request payment for more than one year from the
balance sheet date
It is probable that the company will resolve the violation of the debt agreement within a
specified grace period, preventing it from becoming callable
Short-term debt that is expected to be refinanced on a long-term basis may be excluded from
the current liability classification if the company has both the intent to refinance on a long-term
basis and the ability to refinance. The ability to refinance means the company has done one of
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 7
the following: issued long-term obligations or equity securities after the date of its balance sheet
but before it is issued, or entered into a long-term financing agreement before it issues the
balance sheet that clearly permits the company to refinance the short-term obligations on a
long-term basis.
When a company’s board of directors declares a dividend, it reduces retained earnings and
recognizes a current liability. The company eliminates the liability on the date of payment.
There are two exceptions to the recording of dividends as current liabilities: a stock dividend
(payable in shares of stock) is treated as an element of stockholders’ equity and undeclared
dividends in arrears on cumulative preferred stock are not a liability until declared but are
disclosed in the notes to the financial statements.
Advances and refundable deposits may be required as guarantees to cover equipment used
by the customer, to cover payments that may arise in the future, or to guarantee performance
of a contract or service. Because these deposits are either refundable or later offset against
receivables, they represent liabilities.
Property taxes are assessed by municipal, county, and some state governments based on the
value of certain property the company owns. The property taxes become a lien, a legal liability
against property that a company owns. A company should estimate and accrue property taxes
in equal monthly amounts during the fiscal period of the taxing authority. Any difference
between actual and estimated property taxes is treated as a change in accounting estimate.
Unconditional purchase obligations do not possess essential characteristics of a liability and
generally are not recorded until the obligating event occurs. However, if the market price falls
below the set purchase price, the company accrues a loss and records a liability.
Relevant Examples and Exhibits

Real Report 9.1 Starbucks’s Current Liabilities
Current Liabilities with Amounts Determined by Operating Activities
Accrued liabilities are expenses incurred but not yet paid. Most of these liabilities and related
expenses are recorded as end of the period adjusting entries.
All companies incur liabilities related to compensating employees. These liabilities include
salaries, required employee withholdings, voluntary employee deductions, and payroll taxes.
Liabilities for compensated absences and bonuses are also treated as current liabilities.
Federal, most state, and some local governments require employees to withhold anticipated
income taxes payable to the governmental unit. Federal Insurance Contribution Act (F.I.C.A.)
taxes, also referred to as social security taxes, are taxes required by social security legislation
that employers are required to withhold from the wages of each employee plus the amount
owed by employers for the employee (in addition to amounts withheld from employees’
wages). These taxes are known as social security taxes and serve to pay Old-Age, Survivor, and
Disability Insurance (O.A.S.D.I.) benefits and medicare, or federal hospital insurance benefits.
Federal Unemployment Tax Act (F.U.T.A.) is legislation that requires employers to pay a tax used
to make payments for a limited time to individuals who become unemployed. The maximum
tax rate is 6.0% on the first $7,000 paid to each employee. States receive 5.4% of this amount
making the net effective federal rate 0.6%.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 8
Contractual arrangements often result in voluntary payroll deductions for things like group health
insurance, accident insurance, life insurance, union dues, and tax-sheltered retirement savings.
The deductions are made for the convenience of the employees.
Compensated absences are absences from work that include vacation, holiday, illness, or other
personal activities for which a company pays its employees. Expenses are recognized and
liabilities accrued if all of the following conditions are met:




The company’s obligation is based on employee’s services already rendered.
The obligation relates to rights that vest (the employee will be paid even if employment is
terminated) or accumulate (unused benefits can be carried forward to a period
subsequent to when they are earned).
Payment of the compensation is probable.
The amount can be reasonably estimated.
A company must accrue a current liability for vested or accumulated unused vacation benefits
and vested unused sick pay benefits. A company may accrue a current liability for
accumulated (but not vested) sick pay benefits.
Companies establish earnings-based bonus agreements to provide incentives for executives
and managers to increase company earnings. Bonuses are typically triggered only after
earnings meet and exceed specified levels. The accrual of bonuses is treated as operating
expenses and current liabilities.
A sales tax is a tax levied by a governmental authority (such as a state and local government)
on the transfer of certain goods and services. The seller collects the sales tax from the customer
and treats the amount as a liability until it is remitted to the governmental authority. A use tax is
a tax levied by a state or local governmental unit on goods bought from a nonsales-tax area or
sector. It is levied on the buyer of merchandise and is treated in essentially the same manner as
a sales tax.
The income of corporations is subject to federal income tax and may also be subject to state,
local, and foreign income taxes. The accrual of taxes is recorded as on expense and current
liability.
Unearned revenues (deferred revenues) are liabilities that include amounts a company has
collected in advance but has not yet earned and, therefore, cannot be recorded as revenues.
Unearned revenues are reported as current or long-term liabilities depending on the length of
the company’s earnings process. An adjusting entry is recorded at the end of the accounting
period to reflect revenue earned and reduce the liability.
Relevant Examples and Exhibits







Exhibit 9.2 Payroll Taxes and Voluntary Deductions
Example: Accounting for Withholdings, Payroll Taxes, and Deductions
Exhibit 9.3 Accounting for Compensated Absences
Example: Compensated Absence – Vacation Benefits
Example: Bonus Computation
Example: Sales Tax Separate from Sales
Example: Sales Tax Included in Sales
Contingent Obligations
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 9
In normal operations transactions, events, and commercial arrangements sometimes give rise to
uncertainty about whether the company will experience a future gain or loss, become
obligated to make payments, or become entitled to receive payments. This uncertainty will
ultimately be resolved at some future date. A contingency is an existing condition, situation, or
set of circumstances involving uncertainty as to a possible gain (a “gain” contingency) or loss ( a
“loss” contingency) that will be resolved when a future event occurs or fails to occur.
A loss contingency is an existing situation in which there is a potential decrease in assets or a
potential increase in liabilities, dependent on the occurrence of some future event. The
uncertainty can vary widely and the level of uncertainty influences the accounting for and
reporting of the uncertainty. GAAP requires a company to categorize likelihood of occurrence
of a future event that will confirm the loss as:



Probable – the degree of uncertainty about a future event in which the future event’s
chance of occurring is deemed as being likely to occur.
Reasonably possible – the degree of uncertainty about a future event in which the future
event’s chance of occurring is deemed more than remote but less than likely.
Remote – the degree of uncertainty about a future event in which the future event’s
chance of occurring is deemed slight.
A company accrues an estimated loss from a loss contingency and a corresponding liability if
both of the following conditions are met:


The company has information prior to issuing its financial statements that indicates it is
probable that a liability has been incurred at the date of the financial statements.
The company can reasonably estimate the amount of the loss.
If either of the preceding two conditions are not met but there is a reasonable possibility that a
loss may have been incurred, a loss contingency is disclosed in the notes to the financial
statements. Some remote loss contingencies are also disclosed in the notes to the financial
statements when written guarantees exist.
Differences in regard to contingencies between IFRS and U.S. GAAP are:



Terminology – under IFRS provision is used in place of contingency.
Recognition differences – IFRS defines probable as more likely than not, requires
recognition if it is probable that an event has occurred, and requires disclosure of gain
contingencies in notes to the financial statements.
Measurement differences – IFRS requires measurement of the contingent liability using
present value techniques, and requires use of midpoint if range of liability used for
estimate.
For pending litigation, the loss and related liability will be accrued if:



The cause of the litigation has occurred before the date of the financial statements.
It is probable the outcome of the lawsuit will result in a loss for the company.
The amount of the loss can be reasonably estimated.
In practice, companies usually do not accrue losses and liabilities for the costs of actual or
pending litigation.
A product warranty is an agreement that requires a seller, over a specified time after the sale, to
correct any defect in the quality of the merchandise sold, to replace the item, or to refund the
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 10
selling price. The matching principle requires a company to recognize any warranty costs as an
expense in the period of sale.
The expense warranty accrual method is a method of accounting for warranty costs wherein a
company recognizes the estimated warranty expense and a contingent liability for future
performance in the period of sale. This method assumes the company makes the warranty offer
in order to increase sales. When the company uses its resources to fulfill the warranty, it
decreases the liability and the asset used to satisfy the warranty.
The sales warranty accrual method is a method of accounting for warranties wherein a
company defers revenue from the sale of a warranty contract and generally recognizes it on a
straight-line basis over the life of the contract and generally expenses costs as incurred. This
method treats the warranty as a separate sales transaction.
The modified cash basis method is a method of accounting for warranty costs wherein a
company records warranty costs as an expense during the period in which it makes repairs to
merchandise under warranty. This method violates the matching principle and is conceptually
unsound but may be justified for financial reporting by meeting one of three conditions:



When the warranty period is relatively short, making the cost of estimating the warranty
liability greater than the benefits obtained.
When it is not possible for the company to make a reliable estimate of the warranty
obligation amount at the time of sale.
When the results are not materially different from the expense warranty accrual method
or the sales warranty accrual method.
Premiums are offerings by a company such as toys, dishes, CDs, and small appliances in
exchange for labels, coupons, box tops, and wrappers from its products. Coupons are offerings
by a company of a printed item in newspapers and magazines that can be used to reduce the
purchase price of their products. Cash rebates are cash back to customers who return a cash
register receipt for the purchase of their products. All of these offers are designed to increase a
company’s sales. Therefore, any costs associated with premiums and coupons should be
matched as expenses against revenues in the period of the sale.
A gain contingency is a potential increase in a company’s assets or a potential decrease in its
liabilities, dependent upon the occurrence of some future event. Gain contingencies are
usually not accrued due to application of the conservatism principle. Gain contingencies may
be disclosed in the notes to the financial statements. Gain contingencies are generally
recognized when realized.
Relevant Examples and Exhibits



Exhibit 9.4 Frequency of Common Loss Contingencies
Exhibit 9.5 Reporting a Loss Contingency
Real Report 9.2 Loss Contingency Disclosures
Financial Statement Presentation of Current Liabilities and Contingencies
The FASB suggested the following broad guidelines for reporting assets and liabilities as items on
a balance sheet:

Assets and liabilities with different implications for financial flexibility should be reported as
separate items.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities


Instructor’s Manual, p. 11
Assets and liabilities with different liquidity characteristics should be reported as separate
items.
Assets and liabilities that differ regarding measurement attributes should be reported in
separate categories.
Most companies report current liabilities as the first classification under liabilities. Items within the
current liability section typically may be listed in order of their average length of maturity, or
according to amount (largest to smallest), or in the order of liquidation preference (the order of
their legal claims against assets). Current liabilities are usually recorded and reported at their
maturity values.
A company discloses any major issues affecting its current liabilities in a note to its financial
statements. The notes and other supplemental information about current liabilities should meet
the requirement of full disclosure.
Relevant Examples and Exhibits

Real Report 9.3 Disclosure of Current Liabilities
Ethical Dilemma Answer
This ethical dilemma involves the proper classification of workers as employees or independent
contractors. While no hard and fast rules exist, the IRS, courts, and state agencies have focused
on the amount of control the company exerts on the day-to-day activities of the worker in
making this determination. This ethical application draws from a Wall Street Journal article
(January 7, 2005) concerning FedEx’s treatment of its drivers as independent contractors instead
of employees. While the determination of employee status is certainly open to judgment, the
financial impacts can be significant. For the situation above, it is the authors’ judgment that the
employer exerts too much control over the employee to classify the employee as an
independent contractor. A good exercise would be to obtain the Wall Street Journal article
mentioned above, assign it to the students and allow them to draw a conclusion as to FedEx’s
treatment of its employees. The financial statement impacts of this treatment could then be
discussed.
Instructional Notes
GAAP deals directly with accrued liabilities. The four criteria for accruing a liability for
compensated absences can be used as a tool to assist students understand the basic
characteristics of a liability.
For property taxes it is important to remember that GAAP recommends monthly accruals of
property taxes and recognition of the property tax over the fiscal year of the taxing authority.
This latter requirement often means that two rates of property tax will need to be used.
For warranty obligations, it is helpful to point out the basic requirements of GAAP which imply
that the expense warranty accrual method is the theoretically correct method. It is important,
however, to discuss and compare the modified cash basis and the sales warranty accrual
method.
The accounting for contingencies is the most difficult section of this chapter to teach. It is helpful
to define the term contingencies, to state the three likelihood of occurrence – probable,
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Chapter 9: Current Liabilities and Contingent Liabilities
Instructor’s Manual, p. 12
reasonably possible, and remote – and then to emphasize the two basic requirements for
recording the contingency, which are probable and amount that can be reasonably estimated.
Time should be used to discuss the differences between IFRS and U.S. GAAP with a focus on the
lower threshold for recording and the differences in terminology – provision.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.