CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES ...
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
Recognition and Measurement o Liability
IFRS/CICA liability definition: A liability is an obligation that arises from past transactions or events, which may result in a transfer of assets. Liabilities have three essential characteristics: they embody a duty or responsibility the entity has little or no discretion to avoid the duty the transaction or event that obliges the entity has occurred the settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future Current proposed definition: A liability of an entity is a present economic obligation for which the entity is the obligor. Liabilities have three essential characteristics: they exist at the present time o the economic obligation must exist and the entity must be the obligor at the balance sheet date. they represent economic burdens or obligations o an unconditional promise (example: pay interest on borrowed money) or other requirement to provide or forego economic resources. Obligation is not contingent or conditional on a future event. Stand ready obligation, meaning that the obligor stands ready to do whatever is required by the terms of the contract the obligations are enforceable on the obligor entity o a constructive obligation exists (obligations based on entity's present/past actions one that arises from past or present company practice that signals that the entity acknowledges a potential economic burden). o can't pass it to anyone o Financial liabilities and non-financial liabilities Under IFRS and PE GAAP, a financial liability is any liability that is a contractual obligation to either: deliver cash or other financial asset to another party, or to exchange financial instruments with another party under conditions that are potentially unfavourable. Note that this definition require the liability to be based on an obligation that is created by a contract. Income taxes payable and other liabilities from lefisltation are not considered as financial liabilities.
Measurement o Financial liabilities.
Financial liabilities are recognized originally at their fair value. After acquisition they can be measured at amortized cost (except those held for trading, such as derivatives, where fair value is used) Consistent with cost based measurement, transaction costs that are a direct result of the issue of the liability are netted against its original fair value. Alternatively, transaction costs associated with the issue of financial liabilities that are accounted for after acquisition at fair value are recognized in net income as they are incurred. o Non Financial liabilities Non Financial liabilities on the other hand are usually not usually payable in cash. Therefore, they are measured in other way. PE and ASPE do not separately address the issue of non-financial liabilities,
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES so these are measured in a variety of ways depending on the specific liability. Example: unearned revenue is usually measured at the fair value of the goods and services to be delivered in the future, and, where matching is an issue, the obligations are measured based on management's best estimate of the cost of the goods or services to be provided in the future. Under international standards, non financial liabilities are measured initially and at each subsequent reporting date at the best estimate of the amount the entity would rationally pay at the BS date to settle the present obligation. This is usually the present value of the resources needed to fulfill the obligation, measured at the expected value, or probability - weighted average of the range of possible outcomes. Proposals to revise the existing standards indicate that any asset outflows used in these calculations are measured at the amount the company would pay to be relieved of the obligation; that is, at their "exit" value or value in sale, not at their cost of the entity.
Common Current Liabilities o What is a current liability? The definition of a current liability and of the length of the operating cycle (cash to cash cycle) is directly related to that of a current asset. A liability is classified as current under IFRS when one of the following condition is met: it is expected to be settled in the entity's normal operating cycle it is held primarily for trading it is due within 12 months from the end of the reporting period the entity doesn't have an unconditional right to defer its settlement for at least 12 months after the BS datre. PE / GAAP don't have a proper definition but similar in the intent to IFRS. o Bank indebtedness and credit facilities Line of credit (revolving debt). Generally, an agreement entered with the bank that allows multiple borrowings up to a negotiated limit. Repayments are made whenever there are sufficient funds available. The amount of actual bank indebtedness is reported on the BS, while total funds that the credit arrangements allows the company to borrow or any restrictions that are imposed by the financial institution are disclosed in the notes o Accounts Payable Accounts payable or trade accounts payable are amounts owned for goods, supplies or services purchased on open account related to the entity's ordinary business activity. Accounts payable arise because of the time lag between the receipt of the goods and services and the payment for them period generally stated in the terms of sale and purchase. If title has passed to the purchaser before the goods are received, the transaction should be recorded when the title passes. Attention must be paid to transactions that occur near the end of one accounting period and the beginning of the next so that the goods and services received (inventory or expense) are recorded in the same accounting period as the liability (accounts payable) and both are recorded in the proper period. o Notes Payables Notes payable are written promises to pay a sum of money on a specified future date and may arise from purchases, financing or other transactions. Notes may be classified as current or long term (non current), depending on the payment due date. Notes may also be interest bearing or non-interestbearing (i.e. 0 interest bearing) and accounting for them is the mirror image of accounting for notes receivable illustrated in chapt7.
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
Interest bearing note issued
Landscape Corp. borrows $100,000 Signs a 4-month, 12% note on March 1 Entry to record when cash is received on march 1: cash 100000 Notes Payable 100000 If Landscape has a 31/12 YE but prepared FS semi annually, an adjusting entry is required to recognize the 4 months of interest expense and interest payable of $4,000 (100,000*0.12*(4/12)). The adjusting entry is: Interest exp 4,000 Interest payable 4,000 At maturity on July 1, Landscape pays the note's face value of $100,000 plus the $4,000 of interest. The entry to record payment of the note and accrued interest is as follows: Notes payable 100,000 Interest payable 100,000 Cash 104,000
0 interest bearing note issued
Despite its name, a 0 interest bearing note DOES have an interest component. The interest is just not added on top of the note's face or maturity value; instead, it is included in the face amount. The interest is the difference between the amount of cash received when the note is signed and the higher face amount that is payable at maturity. The borrower receives the note's PV in cash and pays back the larger maturity value. To illustrate, assume that Landscape issues a $100,000, 4months, 0 interest bearing note payable to the provincial bank on march 1. The note's PV is $96,154 based on the bank's discount rate of 12%. landscape entry to record this transaction is: Cash 96,154 Notes Payable 96154 Notes payable is credited for the note's fair value, which is less than the cash due at maturity. In effect, this is the amount borrowed. If Landscape prepares FS at June30, the interest expense for the 4month period to June 30 must be recognized along with the increase in the Note payable = 96154 *12%*4/12 = 3,846 as follows: Interest expense 3846 Notes payable 3846 The Note payable account now has a balance of 96154+3846 = 100,000. This is the amount borrowed plus interest to June 30 at 12%. On June 1 the note is repaid: Notes payable 100,000 Cash 100,000 o Current Maturities of LT Debt Bonds, mortgage notes, and other LT indebtedness that mature within 12 months from the BS date - current maturities of LT debt - are reported as current liabilities. When only part of the LT obligation is to be paid within the next 12 months, as in the case of a mortgage or of serial bonds that are to be retired through a series of annual installments, only the maturing portion of the principal of the LT debt is reported as current Liability. The balance is reported as a LT liability Portions of LT debts should not be reported as current liabilities if, by contract, they are retired by assets not classified as current assets
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES A liability that is due on demand (callable by the creditor or that will be due on demand within a year, is also classified as current liability. Often, companies have debt agreements that, while due on demand, have payment schedules set up to pay the obligation over a number of years. The mgmt of these entities argues that only the portion due to be paid within 12 months should be classified as current. Liabilities often become callable by the creditor if there is a violation of the debt agreement. o ST debt expected to be refinanced IFRS has more stringent rules than PE GAAP ST debt obligations are amounts scheduled to mature within one year from the BS date. However, a classification issue arises when such a liability is expected to be refinanced on a LT basis, and therefore Current Assets are not expected to be needed from them. Under IFRS, debt due within 12 months is classified as current, unless at BS date the company has the intent and a right (under existing contract, and solely in its discretion) to refinance with LT debt. Under PE Gaap, currently maturing debt can be classified as LT if there is irrefutable evidence at time of issuing FS that debt has been or will be converted to LT debt. Example: Montavon has $3millio of ST debt at the reporting date. The company then issues 2$million of LT debt after the BS date but before the FS are issued, and uses the proceeds from the issue to liquidate the ST liability. If the net proceeds from the issue of the new LT debt total $2million, only $2million of the ST debt can be excluded from the current liabilities. Under IFRS, the whole $3 million maturing debt would still be classified as a current obligation. That is, the international standard has a more stringent requirement; the agreement must be at the BALANCE SHEET DATE. o Dividends Payable A cash dividend is an amount that a corporation owes to its shareholders because the BOD has authorized a dividend payment. At the dividend declaration date, the corporation incurs a liability that places the SH in the position of creditors for the amount of dividends declared. Because cash dividends are normally paid within one year of declaration, they are classified as CL. Accumulate but undeclared dividends on cumulative preferred shares are not recognized as liability, because preferred dividends in arrears are not an obligation until formal action is taken by the BOD to authorize distribution. Nevertheless, the company is required to disclose the existence of cumulative dividends that are undeclared in a not to the FS. Dividends that are payable in the form of additional shares are not recognized as liability. Such share or stock dividends do not meet the def of a liability, because they don't require future outlays of econ resources. On declaration, an entry is prepared that reduce (debits) RE and credits contributes capital amount such as stock dividends distributable. o Rents and Royalties payable. “This type of liability may be created by a contractual agreement in which payments are conditional on the amount of revenue that is earned or the quantity of product that is produced or extracted.” Examples include the following: – Franchisees often pay the franchisor franchise fees calculated as a % of sales – Tenants in shopping centers may be required to pay additional rents based on sales Liabilities for expenses that are based on revenues earned or units produced are usually easy to measure. For example, if a lease calls for a fixed rent payment of $500 per month
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES and 1% of sales over $300,000 a year, the nnual rent obligation amounts to $6,000 + $0.01 of each dollar of revenue over $300,000. o Customer Advances and deposits. Deposits may be received from customers to guarantee the performance of a contract or service or to guarantee the payment of expected future obligations. For example, telephone companies often require deposits from customers when they install a phone. Some companies require their employees to make deposits for the return of keys or other company property. Deposits Current or LT obligation? Initial classification depends on the conditions attached to he specific deposit. For example, if the entity does not have the right to defer the settlement of the deposit for a period of at least 12 months from the BS date, the deposit is reported as CL. Non-Financial liabilities: Some liabilities are more difficult to measure because the obligations will be met with goods and services (i.e. non financial resources), and the timing of meeting the obligation and its amount are not fixed. Examples include unearned revenue, product guarantees and warranties and obligations under customer loyalty programs. Even though the amount and the timing of these obligations may not be known, whenever they involve unconditional obligations that are enforceable and that exist at the BS date, they are liabilities. o Decommissioning and restoration obligations. The obligation associated with retirement of a long lived asset must be recognized when incurred. This liability is known as an asset retirement obligation (ARO) or site restoration obligation. Existing legal obligations include those related to: 1. Decommissioning nuclear facilities 2. Dismantling, restoring, and reclamation of oil and gas properties, 3. Certain closure, reclamation, and removal costs of mining facilities, and 4. Closure and post-closure costs of landfills
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PE GAAP recognizes cost of legal obligations only, while IFRS also includes constructive obligations Initial measurement at “best estimate of the expenditure required to settle the present obligation” at balance sheet date Need to discount future costs (i.e. present value) since obligation met in the future. Recognition and allocation Capitalized costs are not recorded in separate account, there are added to the carrying amount of the underlying asset and a liability is recognized for the same amount. An asset retirement cost is recorded as part of the cost of the related asset because it is considered necessary in order to acquire and operate the asset, and to receive its econ benefits. Amortized over underlying asset’s useful life either through straight line or other depending on the way the asset is producing. MATCHING COST TO REVENUE.
Illustration
Oil Platform erected January 1, 2011
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES Platform must be dismantled at the end of the useful life: 5 years Estimated cost of dismantling: $1,000,000 Discount rate: 10% PV of the dismantling cost (ARO): $620,920
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Interest must also be recorded because the obligation is initially recorded and reported at PV
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Interest cost classified as
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Accretion expense (under PE GAAP): recognized as an operating expense on the income statement, not recognized as interest or borrowing cost.
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Interest Expense (IFRS): recognized as a borrowing cost
Amount calculated using the same rate used to calculate the PV (the discount rate)
On janauray 10,2016 Wildacat pays rig reclaimers for dismantling the platform at the contract price of $995,000. Wildcat then makes the following entry to record the settlement of liability:
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
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Unearned Revenue
When cash or other assets are received in advance for specific goods or services to be delivered or performed in the future, the entity recognized the obligation as a liability. Examples include gift certificates, prepayment for subsciption. This obligation is a liability for the firm to perform in the future and is referred to as unearned revenue. Company's liability is measured at the fair value of the outstanding obligation and this revenue is then recognzied as the goods are delivered or the services are provided. Cash Unearned then when revenue is earned (service or good is provided) Unearned Revenue Recorded as a current liability. o Product guarantees and customer programs. These are a continuing obligation resulting from the fact that an entity provides customer programs that require goods and services be provided after the initial product or service is delivered. There are two approaches to accounting for the outstanding liability: Expense approach: Liability is measured at cost of meeting the obligation, and expense is matched against period revenues (current). As actual cost are recognized in future periods, the liability decreases. Revenue approach: Liability is measured at value of the service to be provided (not cost) and recognized in revenue as earned (future). Under this approach, the proceeds received for any goods or services to be delivered or performed in the future are unearned at the point os sale. until the revenues is earned, the obligation - liability - is reported at its sales or fair value. The liability is then reduced as the revenue is earned. There are two main differences in these approaches: under the expense approach, the liability is measured at the estimated cost of meeting the obligation. Under the revenue approach, the liability recognized is measured at the value of the service to be provided, not its cost. Under the expense approach, and assuming the estimate of the cost of the obligation to be met in the future is clsoe to the actual future cost, there is no effect on future income. Under the revenue approach, future income is
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES affected. Some amount of unearned revenue is recognized as a liability, and this is recognized as revenue in future periods when it is earned or the performance obligation is met. Any expense associated with that revenue are also recognized in the future. Therefore, future income amounts are affected by the profit or loss earned on the delivery of the goods or services provided in subsequent years. o
Product Guarantees and warranty obligation
Warranties
A warranty (product guarantee) is a promise made by a seller to a buyer to correct problems experienced with a product's quantity, quality or performance. Warranties are commonly used by manufacturers to promote sales. For a specified period of time following the date of sale to the consumer, a manufacturer may promise to be responsible for all or part of the cost of replacing defective parts, to perform any necessary repairs or servicing without charge, to refund the purchase price, or even to double your money back. Warranties and product guarantees are stand ready obligations at the reporting date that result in future costs that are often significant. Expense approach: Under IFRS, warranty cost's estimate is measured using a probability weighted expected value while PE GAAP will probably use the value of the most likely estimate.
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
Cash Base approach
Warranty costs charged to the period in which the costs are paid – No estimated liability recorded or reported Acceptable for accounting purposes when: – Warranty costs are immaterial, or – Warranty period is relatively short Required for income tax purposes
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Warranty sold separately
Applies to extended product warranties; or warranties sold as separate product (or having standalone value) Accounted for using revenue approach Revenue from warranty sale deferred Recognized over life of the warranty generally using straight-line method Under Revenue approach Under this approach, the warranty service is considered to be a separate deliverable from the underlying product or service sold. It is either sold as a separate service or its price is considered to be bundles with the selling price of the associated good. In the latter case, the amount of revenue attributable to the warranty has to be broken out and recognized separately. Under this method, the proceeds received for (allocated to) the separate service to maintain the product in good order are unearned at the point of sale. The revenue is earned as the warranty service is provided.
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
Customer loyalty program.
Future benefits to the customer in exchange for current sales. Under IFRS, is required the revenue from the original transaction to be allocated between the award credits and the other components of the sale. The fair value of the award credits is recognized as unearned revenue, a liability. This is later recognized in revenue when the award credits are exchanged for the promised awards. Under PE GAAP no specific standard on loyalty programs but similar intent. Premiums and rebates Measured under the expense approach.
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Contingencies and Uncertain commitments
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES Companies are often involved in situtation where it is unvertain whether an obligation to transfer cash or other assets actually exist at the BS date or what amount will be required to settle the obligation. A contingency is an existing condition or situation involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the incurrence of a liability. Current approach to the recognition and measurement of contingencies. Under PE standards, the term contingent liability includes the whole population of existing or possible obligations that depend on the occurrence of one or more future events to confirm either their existence or the amount payable, or both. The approach taken by current standards to deal with whether a liability should be recognized when there is a contingency is to determine the probability of a future even occurring (or not occurring) that would establish whether the outcome is a loss. A contingent loss is recognized in income and as a liability only if both the following conditions are met: - it is likely that a future event will confirm that an asset has been impaired r a liability has been incurred at the date of the FS: the events must have occurred before the BS Date - the loss amount can be reasonably estimated. The evidence that is used to estimate the liability may be the company's own experience, the experience of other companies in the industry, legal advice or educated guesses by personnel who are in the best position known. Disclosure in the notes is still required even if the likelihood is not determinable or cannot establish reasonable estimate. Under IFRS, best estimate and an expected value method to be used to measure the liability. Disclosure is required unless likelihood is remote.
Future Approach to the recognition and measurement of contingencies. Under proposed IFRS changes, term “contingent liabilities” is removed Situation is either a liability (unconditional obligation at balance sheet date) or not Uncertainty about amounts payable in future are considered questions of measurement, and not existence of the liability There is no probability threshold to provide guidance for difficult situations o
Financial Guarantees.
A financial guarantee contract is one where one party (the guarantor) contracts to reimburse the holder for a loss incurred because another party (the debtor) does not make required payments when due. The guarantor has an unconditional obligation to transfer the cash in the future if the debtor fails to meet its obligations. Under PE GAAP, follows rules for loss contingencies with additional disclosure requirements. Under IFRS, the guarantee is recognized initially at fair value, usually equal to the premium charged by the guarantor. After this, it is measured at the higher of: - the best estimate of the payment that would be needed to settle the obligation at the reporting date - best estimate if single obligation will be the most likely amount. If multiple obligations, TVM has to be taken into account if the effects are significant. - any unamortized premium received as a fee for the guarantee (unearned revenue). o Commitments. Executory contracts are agreements where neither party has yet performed
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES These commitments are not considered liabilities as at balance sheet date, but they do represent a contractual obligation of future funds Disclosure is required for abnormal commitments or ones that carry significant risks
Presentation, disclosure and analysis.
o Presentation and disclosure of current liabilities. PE, CL presented as first classification of BS Liabilities and SH equity section. Within the CL section, the accounts may be listed in the order of either their maturity or liquidation preference, whichever provides more useful information to the reader of the financial statements. o
Analysis of CL
Current Ratio: Current Assets Current Liabilities Current ratio shows how many dollard of current assets are available for each dollar of current liabilities. Sometimes it is called the working capital ratio. The higher the ratio, the more likely it is that the company can generate cash to pay its currently maturing liabilities. However, current ratio doesn't tell us how liquid they are (i.e. the inventory might be the largest part of CA). Better information may be provided to assess liquidity by eliminating inventories and other non-liquid current assets such as prepaid expenses from the current asset ratio numerator. Acid-Test Ratio or quick ratio: Cash + Marketable Securities + Net Receivables Current Liabilities
Days Payables Outstanding: Average Trade Accounts Payable Average Daily Cost of Goods Sold How long it takes a company to pay its trades payable (determine the average day of the payables).
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Looking ahead.
Changes are expected as a result of the work on the conceptual framework by IASB and FASB As a result, definition of “liability” and application of recognition criteria are expected to change
Recognition and Measurement o Liability
IFRS/CICA liability definition: A liability is an obligation that arises from past transactions or events, which may result in a transfer of assets. Liabilities have three essential characteristics: they embody a duty or responsibility the entity has little or no discretion to avoid the duty the transaction or event that obliges the entity has occurred the settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future Current proposed definition: A liability of an entity is a present economic obligation for which the entity is the obligor. Liabilities have three essential characteristics: they exist at the present time o the economic obligation must exist and the entity must be the obligor at the balance sheet date. they represent economic burdens or obligations o an unconditional promise (example: pay interest on borrowed money) or other requirement to provide or forego economic resources. Obligation is not contingent or conditional on a future event. Stand ready obligation, meaning that the obligor stands ready to do whatever is required by the terms of the contract the obligations are enforceable on the obligor entity o a constructive obligation exists (obligations based on entity's present/past actions one that arises from past or present company practice that signals that the entity acknowledges a potential economic burden). o can't pass it to anyone o Financial liabilities and non-financial liabilities Under IFRS and PE GAAP, a financial liability is any liability that is a contractual obligation to either: deliver cash or other financial asset to another party, or to exchange financial instruments with another party under conditions that are potentially unfavourable. Note that this definition require the liability to be based on an obligation that is created by a contract. Income taxes payable and other liabilities from lefisltation are not considered as financial liabilities.
Measurement o Financial liabilities.
Financial liabilities are recognized originally at their fair value. After acquisition they can be measured at amortized cost (except those held for trading, such as derivatives, where fair value is used) Consistent with cost based measurement, transaction costs that are a direct result of the issue of the liability are netted against its original fair value. Alternatively, transaction costs associated with the issue of financial liabilities that are accounted for after acquisition at fair value are recognized in net income as they are incurred. o Non Financial liabilities Non Financial liabilities on the other hand are usually not usually payable in cash. Therefore, they are measured in other way. PE and ASPE do not separately address the issue of non-financial liabilities,
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES so these are measured in a variety of ways depending on the specific liability. Example: unearned revenue is usually measured at the fair value of the goods and services to be delivered in the future, and, where matching is an issue, the obligations are measured based on management's best estimate of the cost of the goods or services to be provided in the future. Under international standards, non financial liabilities are measured initially and at each subsequent reporting date at the best estimate of the amount the entity would rationally pay at the BS date to settle the present obligation. This is usually the present value of the resources needed to fulfill the obligation, measured at the expected value, or probability - weighted average of the range of possible outcomes. Proposals to revise the existing standards indicate that any asset outflows used in these calculations are measured at the amount the company would pay to be relieved of the obligation; that is, at their "exit" value or value in sale, not at their cost of the entity.
Common Current Liabilities o What is a current liability? The definition of a current liability and of the length of the operating cycle (cash to cash cycle) is directly related to that of a current asset. A liability is classified as current under IFRS when one of the following condition is met: it is expected to be settled in the entity's normal operating cycle it is held primarily for trading it is due within 12 months from the end of the reporting period the entity doesn't have an unconditional right to defer its settlement for at least 12 months after the BS datre. PE / GAAP don't have a proper definition but similar in the intent to IFRS. o Bank indebtedness and credit facilities Line of credit (revolving debt). Generally, an agreement entered with the bank that allows multiple borrowings up to a negotiated limit. Repayments are made whenever there are sufficient funds available. The amount of actual bank indebtedness is reported on the BS, while total funds that the credit arrangements allows the company to borrow or any restrictions that are imposed by the financial institution are disclosed in the notes o Accounts Payable Accounts payable or trade accounts payable are amounts owned for goods, supplies or services purchased on open account related to the entity's ordinary business activity. Accounts payable arise because of the time lag between the receipt of the goods and services and the payment for them period generally stated in the terms of sale and purchase. If title has passed to the purchaser before the goods are received, the transaction should be recorded when the title passes. Attention must be paid to transactions that occur near the end of one accounting period and the beginning of the next so that the goods and services received (inventory or expense) are recorded in the same accounting period as the liability (accounts payable) and both are recorded in the proper period. o Notes Payables Notes payable are written promises to pay a sum of money on a specified future date and may arise from purchases, financing or other transactions. Notes may be classified as current or long term (non current), depending on the payment due date. Notes may also be interest bearing or non-interestbearing (i.e. 0 interest bearing) and accounting for them is the mirror image of accounting for notes receivable illustrated in chapt7.
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
Interest bearing note issued
Landscape Corp. borrows $100,000 Signs a 4-month, 12% note on March 1 Entry to record when cash is received on march 1: cash 100000 Notes Payable 100000 If Landscape has a 31/12 YE but prepared FS semi annually, an adjusting entry is required to recognize the 4 months of interest expense and interest payable of $4,000 (100,000*0.12*(4/12)). The adjusting entry is: Interest exp 4,000 Interest payable 4,000 At maturity on July 1, Landscape pays the note's face value of $100,000 plus the $4,000 of interest. The entry to record payment of the note and accrued interest is as follows: Notes payable 100,000 Interest payable 100,000 Cash 104,000
0 interest bearing note issued
Despite its name, a 0 interest bearing note DOES have an interest component. The interest is just not added on top of the note's face or maturity value; instead, it is included in the face amount. The interest is the difference between the amount of cash received when the note is signed and the higher face amount that is payable at maturity. The borrower receives the note's PV in cash and pays back the larger maturity value. To illustrate, assume that Landscape issues a $100,000, 4months, 0 interest bearing note payable to the provincial bank on march 1. The note's PV is $96,154 based on the bank's discount rate of 12%. landscape entry to record this transaction is: Cash 96,154 Notes Payable 96154 Notes payable is credited for the note's fair value, which is less than the cash due at maturity. In effect, this is the amount borrowed. If Landscape prepares FS at June30, the interest expense for the 4month period to June 30 must be recognized along with the increase in the Note payable = 96154 *12%*4/12 = 3,846 as follows: Interest expense 3846 Notes payable 3846 The Note payable account now has a balance of 96154+3846 = 100,000. This is the amount borrowed plus interest to June 30 at 12%. On June 1 the note is repaid: Notes payable 100,000 Cash 100,000 o Current Maturities of LT Debt Bonds, mortgage notes, and other LT indebtedness that mature within 12 months from the BS date - current maturities of LT debt - are reported as current liabilities. When only part of the LT obligation is to be paid within the next 12 months, as in the case of a mortgage or of serial bonds that are to be retired through a series of annual installments, only the maturing portion of the principal of the LT debt is reported as current Liability. The balance is reported as a LT liability Portions of LT debts should not be reported as current liabilities if, by contract, they are retired by assets not classified as current assets
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES A liability that is due on demand (callable by the creditor or that will be due on demand within a year, is also classified as current liability. Often, companies have debt agreements that, while due on demand, have payment schedules set up to pay the obligation over a number of years. The mgmt of these entities argues that only the portion due to be paid within 12 months should be classified as current. Liabilities often become callable by the creditor if there is a violation of the debt agreement. o ST debt expected to be refinanced IFRS has more stringent rules than PE GAAP ST debt obligations are amounts scheduled to mature within one year from the BS date. However, a classification issue arises when such a liability is expected to be refinanced on a LT basis, and therefore Current Assets are not expected to be needed from them. Under IFRS, debt due within 12 months is classified as current, unless at BS date the company has the intent and a right (under existing contract, and solely in its discretion) to refinance with LT debt. Under PE Gaap, currently maturing debt can be classified as LT if there is irrefutable evidence at time of issuing FS that debt has been or will be converted to LT debt. Example: Montavon has $3millio of ST debt at the reporting date. The company then issues 2$million of LT debt after the BS date but before the FS are issued, and uses the proceeds from the issue to liquidate the ST liability. If the net proceeds from the issue of the new LT debt total $2million, only $2million of the ST debt can be excluded from the current liabilities. Under IFRS, the whole $3 million maturing debt would still be classified as a current obligation. That is, the international standard has a more stringent requirement; the agreement must be at the BALANCE SHEET DATE. o Dividends Payable A cash dividend is an amount that a corporation owes to its shareholders because the BOD has authorized a dividend payment. At the dividend declaration date, the corporation incurs a liability that places the SH in the position of creditors for the amount of dividends declared. Because cash dividends are normally paid within one year of declaration, they are classified as CL. Accumulate but undeclared dividends on cumulative preferred shares are not recognized as liability, because preferred dividends in arrears are not an obligation until formal action is taken by the BOD to authorize distribution. Nevertheless, the company is required to disclose the existence of cumulative dividends that are undeclared in a not to the FS. Dividends that are payable in the form of additional shares are not recognized as liability. Such share or stock dividends do not meet the def of a liability, because they don't require future outlays of econ resources. On declaration, an entry is prepared that reduce (debits) RE and credits contributes capital amount such as stock dividends distributable. o Rents and Royalties payable. “This type of liability may be created by a contractual agreement in which payments are conditional on the amount of revenue that is earned or the quantity of product that is produced or extracted.” Examples include the following: – Franchisees often pay the franchisor franchise fees calculated as a % of sales – Tenants in shopping centers may be required to pay additional rents based on sales Liabilities for expenses that are based on revenues earned or units produced are usually easy to measure. For example, if a lease calls for a fixed rent payment of $500 per month
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES and 1% of sales over $300,000 a year, the nnual rent obligation amounts to $6,000 + $0.01 of each dollar of revenue over $300,000. o Customer Advances and deposits. Deposits may be received from customers to guarantee the performance of a contract or service or to guarantee the payment of expected future obligations. For example, telephone companies often require deposits from customers when they install a phone. Some companies require their employees to make deposits for the return of keys or other company property. Deposits Current or LT obligation? Initial classification depends on the conditions attached to he specific deposit. For example, if the entity does not have the right to defer the settlement of the deposit for a period of at least 12 months from the BS date, the deposit is reported as CL. Non-Financial liabilities: Some liabilities are more difficult to measure because the obligations will be met with goods and services (i.e. non financial resources), and the timing of meeting the obligation and its amount are not fixed. Examples include unearned revenue, product guarantees and warranties and obligations under customer loyalty programs. Even though the amount and the timing of these obligations may not be known, whenever they involve unconditional obligations that are enforceable and that exist at the BS date, they are liabilities. o Decommissioning and restoration obligations. The obligation associated with retirement of a long lived asset must be recognized when incurred. This liability is known as an asset retirement obligation (ARO) or site restoration obligation. Existing legal obligations include those related to: 1. Decommissioning nuclear facilities 2. Dismantling, restoring, and reclamation of oil and gas properties, 3. Certain closure, reclamation, and removal costs of mining facilities, and 4. Closure and post-closure costs of landfills
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PE GAAP recognizes cost of legal obligations only, while IFRS also includes constructive obligations Initial measurement at “best estimate of the expenditure required to settle the present obligation” at balance sheet date Need to discount future costs (i.e. present value) since obligation met in the future. Recognition and allocation Capitalized costs are not recorded in separate account, there are added to the carrying amount of the underlying asset and a liability is recognized for the same amount. An asset retirement cost is recorded as part of the cost of the related asset because it is considered necessary in order to acquire and operate the asset, and to receive its econ benefits. Amortized over underlying asset’s useful life either through straight line or other depending on the way the asset is producing. MATCHING COST TO REVENUE.
Illustration
Oil Platform erected January 1, 2011
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES Platform must be dismantled at the end of the useful life: 5 years Estimated cost of dismantling: $1,000,000 Discount rate: 10% PV of the dismantling cost (ARO): $620,920
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Interest must also be recorded because the obligation is initially recorded and reported at PV
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Interest cost classified as
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Accretion expense (under PE GAAP): recognized as an operating expense on the income statement, not recognized as interest or borrowing cost.
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Interest Expense (IFRS): recognized as a borrowing cost
Amount calculated using the same rate used to calculate the PV (the discount rate)
On janauray 10,2016 Wildacat pays rig reclaimers for dismantling the platform at the contract price of $995,000. Wildcat then makes the following entry to record the settlement of liability:
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
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Unearned Revenue
When cash or other assets are received in advance for specific goods or services to be delivered or performed in the future, the entity recognized the obligation as a liability. Examples include gift certificates, prepayment for subsciption. This obligation is a liability for the firm to perform in the future and is referred to as unearned revenue. Company's liability is measured at the fair value of the outstanding obligation and this revenue is then recognzied as the goods are delivered or the services are provided. Cash Unearned then when revenue is earned (service or good is provided) Unearned Revenue Recorded as a current liability. o Product guarantees and customer programs. These are a continuing obligation resulting from the fact that an entity provides customer programs that require goods and services be provided after the initial product or service is delivered. There are two approaches to accounting for the outstanding liability: Expense approach: Liability is measured at cost of meeting the obligation, and expense is matched against period revenues (current). As actual cost are recognized in future periods, the liability decreases. Revenue approach: Liability is measured at value of the service to be provided (not cost) and recognized in revenue as earned (future). Under this approach, the proceeds received for any goods or services to be delivered or performed in the future are unearned at the point os sale. until the revenues is earned, the obligation - liability - is reported at its sales or fair value. The liability is then reduced as the revenue is earned. There are two main differences in these approaches: under the expense approach, the liability is measured at the estimated cost of meeting the obligation. Under the revenue approach, the liability recognized is measured at the value of the service to be provided, not its cost. Under the expense approach, and assuming the estimate of the cost of the obligation to be met in the future is clsoe to the actual future cost, there is no effect on future income. Under the revenue approach, future income is
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES affected. Some amount of unearned revenue is recognized as a liability, and this is recognized as revenue in future periods when it is earned or the performance obligation is met. Any expense associated with that revenue are also recognized in the future. Therefore, future income amounts are affected by the profit or loss earned on the delivery of the goods or services provided in subsequent years. o
Product Guarantees and warranty obligation
Warranties
A warranty (product guarantee) is a promise made by a seller to a buyer to correct problems experienced with a product's quantity, quality or performance. Warranties are commonly used by manufacturers to promote sales. For a specified period of time following the date of sale to the consumer, a manufacturer may promise to be responsible for all or part of the cost of replacing defective parts, to perform any necessary repairs or servicing without charge, to refund the purchase price, or even to double your money back. Warranties and product guarantees are stand ready obligations at the reporting date that result in future costs that are often significant. Expense approach: Under IFRS, warranty cost's estimate is measured using a probability weighted expected value while PE GAAP will probably use the value of the most likely estimate.
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
Cash Base approach
Warranty costs charged to the period in which the costs are paid – No estimated liability recorded or reported Acceptable for accounting purposes when: – Warranty costs are immaterial, or – Warranty period is relatively short Required for income tax purposes
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Warranty sold separately
Applies to extended product warranties; or warranties sold as separate product (or having standalone value) Accounted for using revenue approach Revenue from warranty sale deferred Recognized over life of the warranty generally using straight-line method Under Revenue approach Under this approach, the warranty service is considered to be a separate deliverable from the underlying product or service sold. It is either sold as a separate service or its price is considered to be bundles with the selling price of the associated good. In the latter case, the amount of revenue attributable to the warranty has to be broken out and recognized separately. Under this method, the proceeds received for (allocated to) the separate service to maintain the product in good order are unearned at the point of sale. The revenue is earned as the warranty service is provided.
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES
Customer loyalty program.
Future benefits to the customer in exchange for current sales. Under IFRS, is required the revenue from the original transaction to be allocated between the award credits and the other components of the sale. The fair value of the award credits is recognized as unearned revenue, a liability. This is later recognized in revenue when the award credits are exchanged for the promised awards. Under PE GAAP no specific standard on loyalty programs but similar intent. Premiums and rebates Measured under the expense approach.
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Contingencies and Uncertain commitments
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES Companies are often involved in situtation where it is unvertain whether an obligation to transfer cash or other assets actually exist at the BS date or what amount will be required to settle the obligation. A contingency is an existing condition or situation involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the incurrence of a liability. Current approach to the recognition and measurement of contingencies. Under PE standards, the term contingent liability includes the whole population of existing or possible obligations that depend on the occurrence of one or more future events to confirm either their existence or the amount payable, or both. The approach taken by current standards to deal with whether a liability should be recognized when there is a contingency is to determine the probability of a future even occurring (or not occurring) that would establish whether the outcome is a loss. A contingent loss is recognized in income and as a liability only if both the following conditions are met: - it is likely that a future event will confirm that an asset has been impaired r a liability has been incurred at the date of the FS: the events must have occurred before the BS Date - the loss amount can be reasonably estimated. The evidence that is used to estimate the liability may be the company's own experience, the experience of other companies in the industry, legal advice or educated guesses by personnel who are in the best position known. Disclosure in the notes is still required even if the likelihood is not determinable or cannot establish reasonable estimate. Under IFRS, best estimate and an expected value method to be used to measure the liability. Disclosure is required unless likelihood is remote.
Future Approach to the recognition and measurement of contingencies. Under proposed IFRS changes, term “contingent liabilities” is removed Situation is either a liability (unconditional obligation at balance sheet date) or not Uncertainty about amounts payable in future are considered questions of measurement, and not existence of the liability There is no probability threshold to provide guidance for difficult situations o
Financial Guarantees.
A financial guarantee contract is one where one party (the guarantor) contracts to reimburse the holder for a loss incurred because another party (the debtor) does not make required payments when due. The guarantor has an unconditional obligation to transfer the cash in the future if the debtor fails to meet its obligations. Under PE GAAP, follows rules for loss contingencies with additional disclosure requirements. Under IFRS, the guarantee is recognized initially at fair value, usually equal to the premium charged by the guarantor. After this, it is measured at the higher of: - the best estimate of the payment that would be needed to settle the obligation at the reporting date - best estimate if single obligation will be the most likely amount. If multiple obligations, TVM has to be taken into account if the effects are significant. - any unamortized premium received as a fee for the guarantee (unearned revenue). o Commitments. Executory contracts are agreements where neither party has yet performed
ACCT 352 - CHAPT 13 - NON-FINANCIAL AND CURRENT LIABILITIES These commitments are not considered liabilities as at balance sheet date, but they do represent a contractual obligation of future funds Disclosure is required for abnormal commitments or ones that carry significant risks
Presentation, disclosure and analysis.
o Presentation and disclosure of current liabilities. PE, CL presented as first classification of BS Liabilities and SH equity section. Within the CL section, the accounts may be listed in the order of either their maturity or liquidation preference, whichever provides more useful information to the reader of the financial statements. o
Analysis of CL
Current Ratio: Current Assets Current Liabilities Current ratio shows how many dollard of current assets are available for each dollar of current liabilities. Sometimes it is called the working capital ratio. The higher the ratio, the more likely it is that the company can generate cash to pay its currently maturing liabilities. However, current ratio doesn't tell us how liquid they are (i.e. the inventory might be the largest part of CA). Better information may be provided to assess liquidity by eliminating inventories and other non-liquid current assets such as prepaid expenses from the current asset ratio numerator. Acid-Test Ratio or quick ratio: Cash + Marketable Securities + Net Receivables Current Liabilities
Days Payables Outstanding: Average Trade Accounts Payable Average Daily Cost of Goods Sold How long it takes a company to pay its trades payable (determine the average day of the payables).
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Looking ahead.
Changes are expected as a result of the work on the conceptual framework by IASB and FASB As a result, definition of “liability” and application of recognition criteria are expected to change
