Download What is A Current Liability?

Current Liabilities and Contingencies
Overview
With the discussion of investments in the previous chapter we concluded our six-chapter coverage
of assets that began in Chapter 7 with cash and receivables. This is the first of six chapters devoted
to liabilities. Here, we focus on short-term liabilities. Bonds and long-term notes are discussed in
the next chapter. Obligations relating to leases, income taxes, pensions, and other postretirement
benefits are the subjects of the following four chapters. In Part A of this chapter, we discuss open
accounts and notes, accrued liabilities, and other liabilities that are classified appropriately as
current. In Part B we turn our attention to situations in which there is uncertainty as to whether an
obligation really exists. These are designated as loss contingencies.
Learning Objectives
1. Define liabilities and distinguish between current and long-term liabilities.
2. Account for the issuance and payment of various forms of notes and record the interest on the
notes.
3. Characterize accrued liabilities and liabilities from advance collection, and describe when and
how they should be recorded.
4. Determine when a liability can be classified as a noncurrent obligation.
5. Identify situations that constitute contingencies and the circumstances under which they should
be accrued.
6. Demonstrate the appropriate accounting treatment for contingencies, including unasserted claims
and assessments.
7. Discuss the primary differences between U.S. GAAP and IFRS with respect to current liabilities
and contingencies.
Lecture Outline
Part A: Current Liabilities
I.
Characteristics of Liabilities (T13-1)
A. Most liabilities obligate the debtor to pay cash at specified times and result from legally
enforceable agreements.
B. Some liabilities are not contractual obligations and may not be payable in cash.
C. A liability is a present obligation to sacrifice assets in the future because of something that
already has occurred.
II. What is a Current Liability? (T13-2)
A. Classifying liabilities as either current or long-term helps investors and creditors assess the
relative risk of a business’s liabilities.
B. Current liabilities are expected to require current assets and usually are payable within one
year.
C. Current liabilities ordinarily are reported at their maturity amounts. (T13-3)
1. Practical expediency
2. Conceptually, liabilities should be recorded at their present values.
3. Relatively short time to maturity
III. Accounts Payable and Notes
A. Open accounts and notes
1. Accounts payable – Buying merchandise on account in the ordinary course of business
creates accounts payable
2. Trade notes payable – Formally recognized by a written promissory note; sometimes
bear interest
B. Short-term notes payable
1. Line of credit – allows a company to borrow cash without having to follow formal loan
procedures and paperwork
2. Interest on notes – face amount x annual rate x time to maturity (T13-4)
3. Noninterest-bearing notes – interest is “discounted” from the face amount of a note;
the effective interest rate is higher than the stated discount rate (T13-5)
4. Secured loans – a specified asset (often inventory or accounts receivable) is pledged as
collateral or security for the loan
C. Commercial paper (Exercise 13-3)
1. Large, highly rated firms
2. Lower rate than through a bank loan
3. Unsecured notes sold in minimum denominations of $25,000
4. Maturities ranging from 30 to 270 days
5. Interest often discounted at the issuance of the note
6. Usually backed by a line of credit
7. Recording its issuance and payment exactly the same as forms of notes payable
IV. Accrued Liabilities (T13-6)
A. Represent expenses already incurred, but for which cash has yet to be paid (accrued
expenses)
B. Recorded by adjusting entries at the end of the reporting period
C. Common examples: salaries and wages payable, income taxes payable, and interest
payable (T13-7)
D. An employer accrues an expense and related liability for employees' compensation for
future absences such as vacation pay if the obligation meets four conditions:
1. The obligation is attributable to employees' services already performed.
2. The paid absence can be taken in a later year – the benefit vests (will be
compensated even if employment is terminated) or the benefit can be accumulated
over time.
3. Payment is probable.
4. The amount can be reasonably estimated.
V. Liabilities from Advance Collection
A. Deposits and advances from customers (T13-8)
1. Collecting cash from a customer as a refundable deposit or as an advance payment for
products or services
2. Creates a liability to return the deposit or to supply the products or services.
B. Gift cards are a common example of advanced collection. Record unearned revenue
liability when sell the card, and then reduce it and recognize revenue if the gift card is
redeemed or the probability of redemption is viewed as remote.
C. Collections for third parties
1. Sales taxes collected from customers represent liabilities until remitted.
2. Payroll-related deductions such as withholding taxes, social security taxes, employee
insurance, employee contributions to retirement plans, and union dues [discussed in
the Appendix]
VI. A Closer Look at the Current and Noncurrent Classification
A. Current maturities of long-term debt (Exercise 13-10)
1. The currently maturing portion of a long-term debt must be reported as a current
liability.
2. Long-term liabilities that are due on demand – by terms of the contract or violation of
contract covenants – must be reported as current liabilities.
B. Short-term obligations can be reported as noncurrent liabilities if the company:
1. Intends to refinance on a long-term basis and
2. Demonstrates the ability to do so by a refinancing agreement or by actual financing.
(T13-9)
3. Under U.S. GAAP, liabilities payable within the coming year are classified as longterm liabilities if refinancing is completed before date of issuance of the financial
statements. Under IFRS, refinancing must be completed before the balance sheet date.
The FASB is considering an exposure draft proposing the IFRS method. (T13-10)
Part B: Contingencies
I.
Loss Contingencies (T13-11)
A. Involves an existing uncertainty as to whether a loss really exists, where the uncertainty
will be resolved only when some future event occurs
B. Accrued only if a loss is
1. Probable and
2. The amount can reasonably be estimated. (T13-12)
C. The contingent liability for product warranties almost always is accrued. (Exercise 13-13)
D. The contingent liability for premiums (like cash rebates) almost always is accrued. (T1313)
E. When the cause of a loss contingency occurs before the year-end, a clarifying event before
financial statements are issued can be used to determine how the contingency is reported.
(T13-14)
II. Unasserted Claims and Assessments (T13-15)
A. It must be probable that an unasserted claim or assessment or an unfiled lawsuit will occur
before considering whether and how to report the possible loss.
1. Is a claim or assessment probable? {If not, no disclosure is needed.}
2. Only if a claim or assessment is probable should we evaluate (a) the likelihood of an
unfavorable outcome and (b) whether the dollar amount can be estimated, accruing and
disclosing under the same circumstances we would use for a claim that had already
been asserted.
B. If the conclusion of step 1 is that the claim or assessment is not probable, no further action
is required.
III. Gain Contingencies (T13-16)
A. Gain contingencies are not accrued.
B. Conservatism
IV. IFRS (T13-17) Several important differences:
A. IFRS refers to accrued liabilities as “provisions,” and refers to possible obligations that are
not accrued as “contingent liabilities.” The term “contingent liabilities” is used for all of
these obligations in U.S. GAAP.
B. IFRS requires disclosure (but not accrual) of two types of contingent liabilities: (1)
possible obligations whose existence will be confirmed by some uncertain future events
that the company does not control, and (2) a present obligation for which either it is not
probable that a future outflow will occur or the amount of the future outflow cannot be
measured with sufficient reliability. U.S. GAAP does not make this distinction but
typically would require disclosure of the same contingencies.
C. IFRS defines “probable” as “more likely than not” (greater than 50%), which is a lower
threshold than typically associated with “probable” in U.S. GAAP.
D. If a liability is accrued, IFRS measures the liability as the best estimate of the expenditure
required to settle the present obligation. If there is a range of equally likely outcomes,
IFRS would use the midpoint of the range, while U.S. GAAP requires use of the low end
of the range.
E. If the effect of the time value of money is material, IFRS requires the liability to be stated
at present value. U.S. GAAP allows using present values under some circumstances, but
liabilities for loss contingencies like litigation typically are not discounted for time value
of money.
F. IFRS recognizes provisions and contingencies for “onerous” contracts, defined as those in
which the unavoidable costs of meeting the obligations exceed the expected benefits.
Under U.S. GAAP we generally don’t disclose or recognize losses on such money-losing
contracts, although there are some exceptions.
G. Under IFRS, gain contingencies are accrued if their future realization is “virtually certain”
to occur. Under U.S. GAAP, gain contingencies are never accrued.
Decision-Makers’ Perspective (T13-18)
A. Liabilities impact a company’s liquidity.
B. Liquidity refers to a company's cash position and overall ability to obtain cash in the
normal course of business.
C. Critical that managers as well as outside investors and creditors maintain close scrutiny of
a company’s liquidity
D. The current ratio is a measure of short-term solvency.
1. Determined by dividing current assets by current liabilities
2. Should be evaluated in the context of the industry in which the company operates and
other specific circumstances
3. But one indication of liquidity
4. Acid-test or quick ratio, by eliminating current assets such as inventories and prepaid
expenses that are less readily convertible into cash, provides a more rigorous
indication of a company's short-term solvency.
E. Outside analysts as well as managers should actively monitor risk management activities.
PowerPoint Slides
A PowerPoint presentation of the chapter is available at the textbook website.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or you can
use the disk version of this manual and first modify them to suit your particular needs
or preferences.
CHARACTERISTICS OF LIABILITIES

Most liabilities obligate the debtor to pay cash at specified
times and result from legally enforceable agreements.

Some liabilities are not contractual obligations and may not
be payable in cash.
A liability has three essential characteristics. Liabilities:
1.
are probable, future sacrifices of economic benefits
2.
that arise from present obligations (to transfer goods or
provide services) to other entities
3.
that result from past transactions or events
Notice that the definition of a liability involves the present, the future, and the
past. It is a present responsibility, to sacrifice assets in the future, caused by a
transaction or other event that already has happened.
T13-1
WHAT IS A CURRENT LIABILITY?
Classifying
liabilities as either current or long-term helps
investors and creditors assess the relative risk of a company’s
liabilities.
Generally, current liabilities are payable within one year.
Formally,
current liabilities are expected to require current
assets (or create current liabilities).
Conceptually,
liabilities should be recorded at their present
values, but ordinarily are reported at their maturity amounts.
T13-2
CURRENT LIABILITIES
General Mills, Inc.
Balance Sheet ($ in millions)
May 29, 2011 and May 30, 2010
Assets
[by classification]
Liabilities
CURRENT LIABILITIES:
2011
Accounts payable
$ 995.1
Current portion of long-term debt
1,031.3
Notes payable
311.3
Other current liabilities
1,321.5
Total current liabilities
$3,659.2
LONG-TERM LIABILITIES:
[listed individually]
2010
$849.5
107.3
1,050.1
1,769.1
$3,769.1
Shareholders’ equity
[by source]
Illustration 13–1
T13-3
8: Debt
Notes Payable. The components of notes payable and their
respective weighted average interest rates at the end of the period
are as follows:
2011
Note
Payable
Note
Payable
$ 192.5
118.8
$311.3
0.2%
11.5
4.5%
$ 973.0
77.1
$1,050.1
Dollars in millions:
U.S. commercial paper
Financial institutions
Total notes payable
2010
Weighted
Average
Interest
Rate
Weighted
Average
Interest
Rate
20.3%
10.6
1.1%
To ensure availability of funds, we maintain bank credit lines
sufficient to cover our outstanding short-term borrowings.
Commercial paper is a continuing source of short-term financing.
We issue commercial paper in the United States and Europe. Our
commercial paper borrowings are supported by $2.9 billion of feepaid committed credit lines, consisting of a $1.8 billion facility
expiring in October 2012 and a $1.1 billion facility expiring in
October 2013. We also have $311.8 million in uncommitted credit
lines that support our foreign operations. As of May 29, 2011,
there were no amounts outstanding on the fee-paid committed
credit lines and $118.8 million was drawn on the uncommitted
lines. The credit facilities contain several covenants, including a
requirement to maintain a fixed charge coverage ratio of at least
2.5. We were in compliance with all credit facility covenants as of
May 29, 2011.
Illustration 13–1 (continued)
T13-3 (continued)
NOTE ISSUED FOR CASH
Interest on notes is calculated as:
FACE AMOUNT x ANNUAL RATE x TIME TO MATURITY
On May 1, Affiliated Technologies, Inc., a consumer electronics
firm, borrowed $700,000 cash from First BancCorp under a
noncommitted short-term line of credit arrangement and issued a
6-month, 12% promissory note. Interest was payable at maturity.
May 1
Cash ......................................................
Notes payable ....................................
November 1
Interest expense ($700,000 x 12% x 6/12) ........
Notes payable ........................................
Cash ($700,000 + 42,000).........................
700,000
700,000
42,000
700,000
742,000
Illustration 13-3
T13-4
Noninterest-Bearing Note


The proceeds of the note are reduced by the interest in a
“noninterest-bearing” note.
Situation: $700,000 noninterest-bearing note, with a 12%
“discount rate.” The $42,000 interest is “discounted” at the
outset, rather than explicitly stated:
May 1
Cash (difference)..........................................
Discount on notes ($700,000 x 12% x 6/12)........
Notes payable (face amount) .....................
658,000
42,000
November 1
Interest expense ......................................
Discount on notes ................................
42,000
Notes payable (face amount).........................
Cash .....................................................
700,000
42,000
700,000
700,000
The amount borrowed is only $658,000, but the interest is calculated as the discount
rate times the $700,000 face amount. This causes the effective interest rate to be
higher than the 12% stated rate:
$ 42,000
÷ $658,000
= 6.38%
12/6
x
interest for 6 months
amount borrowed
rate for 6 months
to annualize the rate
__________
= 12.76% effective interest rate
T13-5
ACCRUED LIABILITIES



Liabilities accrue for expenses that are incurred, but not yet
paid.
Recorded by adjusting entries at the end of the reporting
period, prior to preparing financial statements.
Common examples are: salaries and wages payable, income
taxes payable, and interest payable.
T13-6
ACCRUED INTEREST PAYABLE

Assume the fiscal period for Affiliated Technologies ends on
June 30, two months after the 6-month note is issued. The
issuance of the note, intervening adjusting entry, and note
payment would be recorded as shown below:
Issuance of note May 1
Cash ........................................................
Note payable .........................................
700,000
Accrual of interest on June 30
Interest expense ($700,000 x 12% x 2/12) ........
Interest payable ....................................
14,000
Note payment November 1
Interest expense ($700,000 x 12% x 4/12) ........
Interest payable (from adjusting entry) ..........
Note payable ............................................
Cash ($700,000 + 42,000) ............................
28,000
14,000
700,000
700,000
14,000
742,000
Illustration 13-6
T13-7
Customer Advance

A customer advance produces an obligation that is satisfied
when the product or service is provided.
Tomorrow Publications collects magazine subscriptions from
customers at the time subscriptions are sold. Subscription
revenue is recognized over the term of the subscription.
Tomorrow collected $20 million in subscription sales during its
first year of operations.
At December 31, the average
subscription was one-fourth expired.
($ in millions)
When Advance is Collected
Cash ..............................................................
Unearned subscriptions revenue ..............
20
When Product is Delivered
Unearned subscriptions revenue ...................
Subscriptions revenue ...............................
5

20
5
Common example: Gift cards. Earn the revenue when either
the gift card is used or the probability of redemption is viewed
as remote.
Illustration 13-10
T13-8
Short-Term Obligations
Expected to Be Refinanced

Short-term obligations can be reported as noncurrent
liabilities only if the company:
(a) intends to refinance on a long-term basis and
(b) demonstrates the ability to do so

by either an existing refinancing agreement or by actual
financing (prior to the issuance of the financial
statements).

The specific form of the long-term refinancing (bonds,
bank loans, equity securities) is irrelevant when determining
the appropriate classification.

The concept of substance over form.
T13-9
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Under U.S. GAAP, liabilities
payable within the coming year are classified as long-term liabilities if refinancing is
completed before date of issuance of the financial statements. Under IFRS,
refinancing must be completed before the balance sheet date.
Classification of Liabilities to be Refinanced.
T13-10
LOSS CONTINGENCIES



A loss contingency involves an existing uncertainty as to
whether a loss really exists, where the uncertainty will be
resolved only when some future event occurs.
The cause of the uncertainty must occur before the statement
date; otherwise, regardless of the likelihood of the eventual
outcome, no liability could have existed at the statement date.
A liability is accrued if it is both(a) probable that the
confirming event will occur and (b) the amount can be at least
reasonably estimated:
Loss (or expense) ......................
Liability ................................

x,xxx
x,xxx
Some loss contingencies don’t involve liabilities at all.
Some
contingencies when resolved cause a noncash asset to be impaired, so
accruing it means reducing the related asset rather than recording a
liability (e.g. accounts receivable).
T13-11
ACCOUNTING TREATMENT OF LOSS CONTINGENCIES
DOLLAR AMOUNT OF POTENTIAL LOSS
________________________________
Reasonably
Not Reasonably
Known
Estimable
Estimable
LIKELIHOOD
Probable
Reasonably
Possible
Remote
Liability
Accrued
Liability
Accrued
Disclosure
Note
& Disclosure Note & Disclosure Note
Only
_____________________________________________
Disclosure
Disclosure
Disclosure
Note
Note
Note
Only
Only
Only
_____________________________________________
No Disclosure
Required
No Disclosure
Required
No Disclosure
Required
Illustration 13-16
T13-12
PRODUCT WARRANTIES AND GUARANTEES

The contingent liability for product warranties almost always
is accrued.
Caldor Health, a supplier of in-home health care products,
introduced a new therapeutic chair carrying a 2-year warranty
against defects. Estimates based on industry experience indicate
warranty costs of 3% of sales during the first 12 months
following the sale and 4% the next 12 months, totaling 7% that
should be accrued in the year of sale. During December of 2013,
its first month of availability, Caldor sold $2 million of the chairs.
During December
Cash (and accounts receivable) ................
Sales revenue .......................................
December 31, 2013 (adjusting entry)
Warranty expense ([3% + 4%] x $2,000,000).....
Estimated warranty liability .................
2,000,000
2,000,000
140,000
140,000
When customer claims are made and costs are incurred to satisfy
those claims the liability is reduced (let’s say $61,000 in 2014):
Estimated warranty liability ....................
61,000
Cash, wages payable, parts and supplies, etc.
61,000
Illustration 13-17
T13-13
SUBSEQUENT EVENTS

If information becomes available that sheds light on a
contingency that existed when the fiscal year ended, that
information should be used in determining the probability of a
loss contingency materializing and in estimating the amount
of the loss.
Cause of Loss Contingency
Clarification


_____________________________________________________________

Fiscal Year Ends


Financial Statements
If an event giving rise to a contingency occurs after the yearend, a liability should not be accrued.
Cause of Loss Contingency
Clarification
or
Clarification



_____________________________________________________________

Fiscal Year Ends

Financial Statements
T13-14
UNASSERTED CLAIMS AND ASSESSMENTS

It must be probable that an unasserted claim or assessment or
an unfiled lawsuit will occur before considering whether and
how to report the possible loss.
Example: The EPA is in the process of investigation possible
violations of clean air laws at a company’s factory, but has
not proposed a penalty assessment. Since the claim or
assessment is unasserted as yet, a two-step process is involved
in deciding how it should be reported:
1. Is a claim or assessment probable? {If not, no disclosure is
needed.}
2. Only if a claim or assessment is probable should we
evaluate (a) the likelihood of an unfavorable outcome and
(b) whether the dollar amount can be estimated.
 If the conclusion of step 1 is that the claim or
assessment is not probable, no further action is required.
T13-15
GAIN CONTINGENCIES

Uncertain situations that might result in a gain.

Gain contingencies are not accrued.


Desirable to anticipate losses, but recognizing gains should
await their realization.
Should be disclosed in notes to the financial statements.

Care should be taken that the disclosure note not give
"misleading implications as to the likelihood of
realization."
T13-16
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Contingencies.
Loss Contingencies. Accounting for contingencies is part of a
broader international standard, IAS No. 37, “Provisions, Contingent Liabilities and
Contingent Assets.” Overall, accounting for contingent losses under IFRS is quite
similar to accounting under U.S. GAAP. A contingent loss is accrued if it’s both
probable and can be reasonably estimated, and disclosed if it’s of at least a remote
probability. However, there are some important differences:
 IFRS refers to accrued liabilities as “provisions,” and refers to possible obligations
that are not accrued as “contingent liabilities.”
 IFRS requires disclosure (but not accrual) of two types of contingent liabilities:
(1) possible obligations whose existence will be confirmed by some uncertain
future events that the company does not control, and (2) a present obligation for
which either it is not probable that a future outflow will occur or the amount of the
future outflow cannot be measured with sufficient reliability.
 IFRS defines “probable” as “more likely than not” (greater than 50%), which is a
lower threshold than typically associated with “probable” in U.S. GAAP.
 If a liability is accrued, IFRS measures the liability as the best estimate of the
expenditure required to settle the present obligation. If there is a range of
equally likely outcomes, IFRS would use the midpoint of the range, while U.S.
GAAP requires use of the low end of the range.
 If the effect of the time value of money is material, IFRS requires the liability to
be stated at present value.
 IFRS recognizes provisions and contingencies for “onerous” contracts, defined as
those in which the unavoidable costs of meeting the obligations exceed the
expected benefits.
Here’s a portion of a footnote from the 2011 financial statements of Vodafone, which
reports under IFRS:
Note 2: Significant Accounting Policies (in part)
Provisions are recognised when the Group has a present obligation (legal or
constructive) as a result of a past event, it is probable that the Group will be
required to settle that obligation and a reliable estimate can be made of the
amount of the obligation. Provisions are measured at the directors’ best estimate
of the expenditure required to settle the obligation at the balance sheet date and
are discounted to present value where the effect is material.
T13-17
DECISION-MAKERS’ PERSPECTIVE



Current liabilities impact a company’s liquidity. Liquidity
refers to a company's cash position and overall ability to
obtain cash in the normal course of business.
Critical that managers as well as outside investors and
creditors maintain close scrutiny of this aspect of a company’s
well-being.
The current ratio is determined by dividing current assets by
current liabilities.

Compares liabilities that must be satisfied in the near
term with assets that either are cash or will be converted
to cash in the near term.

Like other ratios, acceptability should be evaluated in the
context of the industry in which the company operates
and other specific circumstances. Some companies
manage working capital carefully enough to maintain a
relatively low current ratio by maintaining low
receivables and high payables.

By eliminating current assets such as inventories and
prepaid expenses that are less readily convertible into
cash, the acid-test ratio provides a more rigorous
indication of a company's short-term solvency.
T13-18
DECISION-MAKERS’ PERSPECTIVE (continued)


It’s important to remember that each ratio is but one piece of
the puzzle.

In fact, profitability is probably the best long-run
indication of liquidity.

Turnover ratios help measure the efficiency of asset
management.
Most companies attempt to actively manage the risk
associated with these and other obligations.

It is important for top management and outside analysts
to understand and closely monitor risk management
strategies.

It is similarly important for investors and creditors to
become informed about risks companies face and how
well equipped those companies are in managing that risk.

The risk disclosures and derivative disclosures we
discussed in this and the previous chapter contribute to
that understanding.
T13-18 (continued)
SUGGESTIONS FOR CLASS ACTIVITIES
1.
Business Scenario
Outpost Healthcare, Inc. provides long-term healthcare services primarily through the operation
of nursing centers and hospitals. It operates 380 nursing centers, with 45,627 licensed beds in 35
states, and a rehabilitation therapy business. The following news release appeared in March 2008.
OUTPOST HEALTHCARE ANNOUNCES FISCAL 2007 RESULTS
Company Provides Operating Guidance for Fiscal 2008
Hall, Indiana. (March 5, 2008) – Outpost Healthcare, Inc. (the "Company") (NASDAQ: OUTP)
today announced its operating results for the fourth quarter and fiscal year ended December 31,
2007.
Revenues for the fourth quarter of 2007 grew 7% to $689 million compared to $644 million in the
fourth quarter last year, and net income from operations for the current quarter totaled $15.1 million
or $0.74 per diluted share. Operating results for the fourth quarter of 2007 included an unusual
pretax gain of $3.1 million ($2.3 million net of tax or $0.06 per diluted share) recorded in connection
with the resolution of a loss contingency related to a partnership interest.
Suggestions:
Have the class consider how Outpost might have recorded a gain “in connection with the
resolution of a loss contingency the loss contingency.” What might have led to the loss contingency
being recorded? How did they record it? How would the gain be recorded?
Points to note:
Apparently a previously recorded loss was higher than the ultimate outcome. Such situations are
treated as changes in estimates. That is, no adjustment is made to the original reporting. Instead,
when the estimate turns out to be wrong, a gain is recorded for the overstatement of the loss.
Outpost apparently had felt the loss contingency was both probable and reasonably estimable. The
loss contingency would have been accrued with a debit to a loss and a credit to a liability. The
subsequent gain would be offset with a debit to the liability.
2.
Real World Scenario
The following represents a portion of a recent press release:
FUEL TECH REPORTS SECOND-QUARTER 2009 RESULTS
Mon Aug 10, 2009 6:12 pm EDT
WARRENVILLE, Ill. -(Business Wire)Fuel Tech, Inc. (NASDAQ: FTEK), a world leader in advanced engineering solutions for optimization of
combustion systems and emissions control in utility and industrial applications, today reported results for the
three- and six-month periods ended June 30, 2009.
Second-Quarter 2009
…The Air Pollution Control technology segment (APC segment) generated revenues of $9.2 million, a
decrease of 12% versus the second quarter of 2008. This segment continues to feel the effects of deferred
capital investment by electric utilities and other industrial customers as the combination of an economic
slowdown, reduced electricity demand, shortfalls in cash generation by power providers and ongoing
uncertainty over the ultimate outcome of the Clean Air Interstate Rule (CAIR) served to depress outlays for
NOx control systems. Segment gross margins were 49% versus the 46% reported in the second quarter of
2008. Contributing to the increase was a partial reversal of the first-quarter 2009 contingent loss provision on
an APC contract, which has now been resolved.
Suggestions:
Have the class consider the effect of the loss contingency. What motivated Fuel Tech to reverse
the loss contingency? (Resolution of the contingency at a reduced amount.) How did they record it?
(Reversed part of the prior accrual entry.) Is there any potential for earnings management with loss
contingencies? (Yes, if over accrue in a very good or very bad period, can reverse that later to
benefit income in a future period.)
3.
Dell Analysis
Have students, individually or in groups, go to the most recent Dell annual report at Dell’s web site
at: www.Dell.com/. Ask them to:
1. Compare accounts payable, accrued expenses, and other current liabilities with those in the
annual report that came with the textbook. Are there any discernible trends? How might they
be interpreted?
2. Determine what contingencies are reported in the disclosure notes. Are any accrued?
3. Read “Management's Discussion and Analysis of Results of Financial Condition and Results of
Operations” and determine management‘s view of Dell’s current liquidity.
4.
Professional Skills Development Activities
The following are suggested assignments from the end-of-chapter material that will help your
students develop their communication, research, analysis, and judgment skills.
Communication Skills. In addition to Communication Cases 13-7, 13-8, 13-10, and 13-12,
Judgment Case 13-9 can be adapted to ask students to write a memo to the “veteran Board
member.” Real World Case 13-13 and IFRS case 13-14 are suitable for student
presentation(s). Communication Case 13-7, Real World Case 13-2 and Analysis Case 13-17
do well as group assignments. Ethics Case 13-5 creates good class discussions.
Research Skills. In their professional lives, our graduates will be required to locate and extract
relevant information from available resource material to determine the correct accounting
practice, perhaps identifying the appropriate authoritative literature to support a decision using
the FASB’s Accounting Standards Codification. Exercises 13-26 and 13-27 and Research
Cases 13-1, 13-3, 13-6, and 13-11 provide an excellent opportunity to help students develop
this skill.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct
students to gather, assemble, organize, process, or interpret date to provide options for making
business and investment decisions. In addition to Analysis Cases 13-16 and 13-17, Exercise
13-7, Problems 13-8 and 13-9, and Real World Cases 13-2 and 13-13 also provide
opportunities to develop analysis skills.
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require
students to critically analyze issues to apply concepts learned to business situations in order to
evaluate options for decision-making and provide an appropriate conclusion. In addition to
Judgment Cases 13-4 and 13-9, Trueblood Case 13-6 also requires students to exercise
judgment.
5.
Ethical Dilemma
The chapter contains the following ethical dilemma:
ETHICAL DILEMMA
You are Chief Financial Officer of Camp Industries. Camp is the defendant in a $44 million
class action suit. The company’s legal counsel informally advises you that chances are remote that
the company will emerge victorious in the lawsuit. Counsel feels the company will probably lose
$30 million. You recall that a loss contingency should be accrued if a loss is probable and the
amount can reasonably be estimated. A colleague points out that, in practice, accrual of a loss
contingency for unsettled litigation is rare. After all, disclosure that management feels it is
probable that the company will lose a specified dollar amount would be welcome ammunition for
the opposing legal counsel. He suggests that a loss not be recorded until after the ultimate
settlement has been reached. What do you think?
You may wish to discuss this in class. If so, discussion should include these elements.
Step 1 The Facts:
Camp Industries is the defendant in a $44 million class action suit. Legal Counsel believes that
the company will not win the lawsuit and will probably lose $30 million. GAAP mandates that a
loss contingency should be accrued if the loss is probable and the amount reasonably can be
estimated. In an effort not to influence the decision of the court, you, as CFO, are considering
deferring recognition of the loss until after settlement has been reached.
Step 2 The Ethical Issue and the Stakeholders:
The ethical issue or dilemma is whether your obligation to protect company interests in the
lawsuit is greater than your obligation to provide full disclosure of relevant information to users of
the financial statements.
Stakeholders include you as CFO, other company management, employees, current and future
creditors, current and future investors, and members of the class action suit.
Step 3 Values:
Values include competence, honesty, integrity, objectivity, loyalty to the company, and
responsibility to users of financial statements.
Step 4 Alternatives:
1.
Omit the recognition of the probable loss as a contingent liability on the balance sheet.
2.
Record the probable loss on the income statement and as a liability on the balance sheet.
Step 5 Evaluation of Alternatives in Terms of Values:
1.
Alternative 1 illustrates loyalty to protecting company interests during the trial.
2.
Alternative 2 reflects values of competence, honesty, integrity, objectivity, and
responsibility to users of the financial statements.
Step 6 Consequences:
Alternative 1
Positive Consequences: Opposing legal counsel will not learn about the company’s estimation
of the loss. Positive litigation outcome, though unlikely, will not be hurt.
Negative Consequences: Users of the financial statements would not receive full disclosure.
Alternative 2
Positive Consequences: Users of financial statements would become fully informed of the
pending loss. You would maintain your integrity.
Negative Consequences: You may incur the disfavor higher management and legal counsel and
lose your job. The company may lose the lawsuit or be forced into paying a higher
settlement due to the disclosure. The stock price may suffer with negative consequences to
investors, creditors, employees, and their families.
Note:
In practice, loss contingencies from unsettled lawsuits rarely if ever are
accrued. Disclosure notes typically note the difficulty of predicting court
decisions.
Step 7 Decision:
Student(s) must decide their course of action.