chapter 9

CURRENT LIABILITIES, CONTINGENCIES, AND COMMITMENTS

Good Payroll Systems Help Keep Employees Happy

Mountain Equipment Co-op sells outdoor clothing and gear in stores across Canada, and worldwide through its catalogue and website. Founded in 1971, MEC has a reputation among its members for its helpful, knowledgeable staff, with some 1,670 employees working at its stores in Victoria, Vancouver, North Vancouver, Edmonton, Calgary, Winnipeg, Burlington, Toronto, Ottawa, Montreal, Longueuil, Quebec City, and Halifax, as well as its Vancouver call centre.

As a consumer co-operative—customers pay $5 for a lifetime membership—MEC depends on the dedication of its personnel, including sales staff, who are all active outdoor enthusiasts themselves and do not receive commissions. This is why Controller Doug Wong considers payroll to be the most important aspect of MEC's accounting for liabilities. “Payroll is a huge area,” he explains. “In fact, it is our biggest operating expense. It's also an area where there is little margin for error—pay reflects how valued employees feel, and they are understandably sensitive about it. So we endeavour to have accurate payroll, and we do.”

Four full-time staff members at MEC's Vancouver head office handle all payroll functions for the stores across Canada, which have salaried and hourly, full- and part-time employees. While inventory, general accounting, and warehouse operations are managed by one program, MEC uses a separate system for payroll. The routine calculations for pay, deductions (for income taxes, the Canada Pension Plan, and Employment Insurance), and benefits (both statutory benefits and supplemental disability and premium health-care plans) is straightforward with today's computerized accounting systems. However, exceptions, such as provincial variations in rules for holiday pay, enhancements to company-sponsored employee benefits like bike and computer loans, or employees leaving, require human intervention or additional calculations.

In the past, hourly employees would fill in time sheets manually, and payroll clerks would then manually enter that data. But MEC implemented an automated time-capture system in 2004. Hourly workers, who are the majority of MEC staff, swipe a card as they arrive and leave, and the number of hours they work is automatically entered into the system, Mr. Wong explains. “This has eliminated much of the data entry work of the payroll group. Now, most of their time is spent dealing with employment changes—new hires, pay changes, leaves of absence, end of employment issues, etc. They also do a fair bit of labour analysis reporting for store and other managers.”

MEC can configure the system to track time in many ways, to not only produce accurate results but also provide information that is useful to management. For example, employees can swipe their cards every time they work in a different area of the store—the floor area, the cash area, the stock room, and so forth—keeping store managers informed about how their resources are being allocated. In addition, when employees are scheduled to work in different areas, the time and attendance system can calculate their pay according to their schedules. “This is an example of where MEC leverages technology to effectively and efficiently manage a business process,” says Mr. Wong.

USER RELEVANCE

Current liabilities represent obligations that the company must settle within the next year (or operating cycle of the business, if that is longer). Most of these obligations—accounts payable, income taxes payable, wages payable, notes payable, and so on—will require outflows of cash. Users can examine the current liabilities to determine how much cash will be required and to estimate when that cash will need to be paid. Examining the current assets, especially cash, accounts receivable, and short-term investments, provides users with information about the availability of cash. We have already talked about determining how quickly inventory is sold and accounts receivable are collected, using turnover ratios. These help users estimate whether enough cash will be available when the various liabilities come due. If there will not be sufficient cash available, the company will have to go to outside sources—taking on additional short- or long-term debt, or issuing more shares—in order to raise additional cash. Understanding a company's short-term cash needs is essential to determining its current financial health and what may need to be done to ensure its long-term viability.

RECOGNITION CRITERIA FOR LIABILITIES

Liabilities represent the company's obligations arising from past transactions or events. Specifically, to be classified as a liability an item must have the following three characteristics:

• It represents a duty, responsibility, or obligation that imposes an economic burden (i.e., it requires the transfer of assets, the performance of services, or the conferring of some other benefit).

  LEARNING OBJECTIVE 1

  Describe the recognition criteria and valuation methods for liabilities.

• It is enforceable; the entity has little or no discretion to avoid the obligation. If the entity does not settle it, the creditor usually has the right to pursue legal action.
• The obligation exists at the present time. The exact amount may not be determined until a later event has occurred, but the underlying transaction or event creating the obligation has already occurred.

What is uncertain about liabilities is usually the dollar value of the assets, services, or other benefits to be given up, and when they will be given up. To avoid uncertainty about the amount and timing of the settlement, some liabilities, such as accounts payable and most loans, have fixed payment schedules and due dates. For example, in loan agreements the interest and principal payments are specified, as are the dates on which those payments are to be made. Other liabilities, such as warranty obligations, have neither fixed amounts nor fixed dates. For example, the settlement of a warranty obligation will depend on when the customer detects a warranty problem and how much cost the company incurs to fix it. Liabilities, therefore, differ in their degree of uncertainty.

If the obligation is conditional upon some future event, a liability might not be recognized in the financial statements. Suppose, for example, that a company is under investigation by the government for alleged chemical contamination of a river. If the company is found negligent, there could be a significant liability if it is required to clean up the contamination and/or a fine is imposed. However, the company may insist that it is not responsible for the contamination and that the probability that it will be found negligent is low. In such a case, no liability will be recorded in the accounts. However, because a significant amount of assets may have to be transferred in the future, the company would generally disclose information about the investigation and the potential obligation in the notes to its financial statements. Under IFRS, such an item is referred to as a contingent liability, meaning that the liability has not been recorded in the accounts, because the obligation is conditional, dependent, or contingent on the occurrence of a low-probability future event.

The ownership criterion that is used for assets does not strictly apply to liabilities, but a similar notion does. Companies should record only those obligations that they will be required to satisfy. For example, if a customer falls on the company's property, sues the company for medical costs, and wins, the company may not be obliged to make the payment. If the company is insured against such claims, the insurance company will make the payment. The company, therefore, would not record the obligation to settle the customer's claim as a liability on its books, because it is the insurance company's obligation. (However, if the insurance does not cover the full amount, the company would record a liability for its portion of the payment.)

It is sometimes hard to determine whether the event giving rise to the obligation has already occurred. For example, in the case of the lawsuit mentioned above, what is the event that gives rise to the obligation? Is it the customer falling, the filing of a lawsuit, or the court's decision? In this case, the probability that an obligation exists increases as each subsequent event occurs. However, the event that gives rise to the ultimate obligation is debatable. More will be said about this later.

Another potentially difficult situation to evaluate can arise when a company signs a binding contract. Suppose, for example, a company signs a contract to purchase 1,000 units of inventory at $30 per unit, to be delivered 60 days from now. Is the signing of the contract the event that gives rise to the obligation to pay for the inventory, or is it the delivery of the inventory? The company's obligation is conditional upon the seller performing its part of the contract, by delivering the goods on time. If the goods are not delivered, then the company will not be obliged to pay. The contract signing creates what is known as a mutually unexecuted contract because, at the time of signing, neither the buyer nor the seller have performed their part of the contract. The seller has not delivered any inventory, and the buyer has not paid any cash. Such contracts are normally not recorded in the accounting system, although the company may include information about them in the notes to its financial statements.

A partially executed contract is one in which one party has performed part or all of its obligation. In the example just given, the contract would be viewed as partially executed if the buyer paid a $3,000 deposit. The buyer would show an outflow of cash of $3,000, and create an asset account for the right to receive inventory valued at $3,000, called “deposits on purchase contracts” (or something similar). The seller would show an inflow of cash of $3,000 and create a liability account to represent its obligation to deliver inventory valued at $3,000. The liability account would probably be called “unearned revenue.” Once inventory valued at $3,000 is delivered to the customer, the obligation will be satisfied and the revenue will be earned. Note that only the amount of the deposit ($3,000) would be recorded at this time, not the full amount of the contract (1,000 units × $30 per unit = $30,000).

VALUATION METHODS FOR LIABILITIES

Just as there are different methods for valuing assets, there are different methods for valuing liabilities. Theoretically, a liability should be valued at its present value on the date it is incurred. In practice, however, there are several other possible valuation methods to be considered.

One way to value a liability is to record it at the gross amount of the obligation—i.e., the total of the payments to be made. For example, if an obligation requires a company to pay $1,000 each month for the next three years, the gross obligation would be $36,000. However, while this amount accurately measures the total payments to be made, it may not accurately measure the company's obligation at the time it is reported on the statement of financial position. For example, suppose the obligation is a rental agreement for a piece of machinery. If the rental agreement can be cancelled at any time, the company is only obligated to pay $1,000 each month. The remaining payments will be an obligation only if it keeps using the machinery. If the contract cannot be cancelled, valuing the liability at the full $36,000 would make more sense.

Another reason why the gross obligation may not adequately measure the liability's value is that it ignores the time value of money. Suppose that, rather than being a rental payment, the $1,000 each month is to repay a loan (including both interest and principal). In this case, the total payments of $36,000 include both the repayment of principal and the payment of interest. However, since interest only accrues as an obligation as time passes, the only liability that exists initially is for the principal of the loan. For example, if the principal amount of the loan is $30,000 the company could settle the obligation at the outset with a payment of $30,000. The difference ($6,000) between this amount and the $36,000 gross amount is the interest that accrues over time. If the initial liability was recorded at the full $36,000, the company's obligation at the present time would be overstated.

To recognize the time value of money, whenever the interest component is significant companies should record their liabilities at their present values. To do so, both the future principal payments and the interest payments are discounted back to the present time, using the appropriate interest rate. (Present value concepts and calculations are discussed in detail in Chapter 10.) Under this valuation system, the company initially records the obligation at its net present value, rather than the gross amount of the future payments to be made. As time passes, interest expense is recorded, which recognizes the cost of the loan and increases the liability, and payments are made, which decrease the liability.

What Is Canadian Practice?

As stated above, liabilities should, theoretically, be recorded at the present value of the future payments. The interest rate that is used should reflect the type of liability, the duration of the obligation, and the company's creditworthiness. Accordingly, short-term notes payable should be recorded at their present values, and the interest on them should be accrued over time.

However, present-value calculations are generally not used for most short-term liabilities, because either no interest is charged on them or the amounts involved are small and the time to maturity is so short that the difference between the present value of the obligations and the gross amount of the payments would not be material. Therefore, they are simply recorded at the gross amounts that are to be paid.

CURRENT LIABILITIES

Current liabilities are those obligations that require the transfer of assets or services within one year or one operating cycle of the company. As just discussed, most of them are carried on the books at their gross amounts. In order for a company to stay solvent (able to pay its debts when they become due), it must have sufficient current assets on hand and/or generated by its operations to pay the current liabilities. Creditors, such as bankers, will often compare a company's total current assets to its total current liabilities to assess its ability to remain viable. Frequently encountered current liabilities are discussed in the following subsections.

Current Liabilities Related to Operating Activities

Accounts Payable

As you know from earlier chapters, accounts payable occur when a company buys goods or services on credit. They are often referred to as trade accounts payable. Payment is generally deferred for a relatively short period of time, such as 30 to 60 days, although longer credit periods are allowed in some industries.

Accounts payable generally do not carry explicit interest charges and are commonly thought of as “free debt.” However, there is sometimes a provision for either a discount for early payment or a penalty for late payment. In such cases, not taking advantage of the discount, or paying a penalty for being late, can be viewed as equivalent to interest charges.

Wages and Other Payroll Liabilities

Wages owed to employees can be another significant current liability. The magnitude depends, in part, on how often the company pays its employees, because the balance in the account reflects the wages that have accrued since the last pay period.

In addition to the wages themselves, most companies provide fringe benefits for employees. These costs—for medical insurance, pensions, vacation pay, and other benefits provided by the employer—must also be recognized in the periods in which they occur. Because these may be paid in periods other than when they are earned by the employees, any unpaid costs have to be accrued and liabilities recorded for them.

Canadian companies are also required to act as government agents in collecting certain taxes. For example, companies must withhold income taxes from employees' wages and remit them to the government. The amounts paid to the employees are reduced by the amounts withheld. While these taxes are not an expense to the company (because they come out of the employees' earnings), the company must nevertheless keep track of the amounts deducted from employees' earnings and report a liability to pay these amounts to the government.

The amount of income tax to be deducted from employees' earnings depends on many factors, including their expected annual earnings and their personal exemptions for income tax purposes. Therefore, in the examples and problems in this text we will simply state the amount of personal income tax that is to be withheld from the employees' pay.

Other items, such as Canada Pension Plan (CPP) or Quebec Pension Plan (QPP) and Employment Insurance (EI) contributions, are also deducted from employees' wages and remitted to the government. This further reduces the net amounts that are received by the employees.

In addition to the amounts that are deducted from employees' wages, companies must make their own payments to the government for CPP or QPP, EI, workers' compensation plan premiums, and in some provinces, public health-care premiums. These amounts are recorded as an expense to the employer and are shown as liabilities until they are remitted to the government.

As of mid-2010, CPP was deducted from employees' earnings at the rate of 4.95%, while the rate for EI deductions was 1.73%. (However, there are exemptions and maximums that can complicate the calculations, and these rates can change from year to year.) In addition to collecting the amounts deducted from employees, employers were also required (at the time of writing) to contribute an amount equal to the employees' deductions for CPP, and 1.4 times the amount deducted from their employees for EI.

For example, assume that the employees of Angelique's Autobody Shop have earned wages of $10,000, and that income tax totalling $2,500 is deducted from the employees' cheques. In addition, $495 (4.95% of $10,000) is deducted for CPP and $173 (1.73% of $10,000) is deducted for EI. Beyond these amounts, the employer has to pay an additional $495 (the same amount as deducted from the employees) for CPP, and $242.20 (1.4 times the $173 deducted from the employees) for EI, as the company's contributions. The journal entries to record the payroll would be as follows:

Note that, although the employees earned $10,000, the amount actually paid to them in this example, after deductions, is only $6,832.00. This is referred to as their net pay.

The amounts in the three liability accounts are remitted periodically to the government, according to its regulations. The following journal entry illustrates the remittance of both the employees' deductions and the employer's contributions:

Note that the total amount recorded by the employer as an expense ($10,000.00 + $737.20 = $10,737.20) exceeds the amount it agreed to pay the employees ($10,000.00). Because of these extra amounts that the government requires businesses to pay, companies are concerned each time the government makes changes to the Canada/Quebec Pension Plan, Employment Insurance scheme, or other compulsory programs—unless of course, the government reduces the rates. Employers must always take these additional amounts (which are commonly referred to as payroll taxes) into account in managing their businesses, because they increase the costs of hiring employees. Workers' Compensation Plan premiums and, in some provinces, public health-care premiums also fall into this category.

Corporate Income Taxes

Canadian companies that are incorporated pay both federal and provincial corporate income taxes, and may also be subject to taxation in other countries in which they operate. As mentioned earlier, the regulations governing the calculation of income for tax purposes differ in many respects from the accounting standards for the calculation of income. (The discussion in Chapter 8 concerning deferred income taxes highlighted this difference; deferred income taxes are discussed in greater detail in Chapter 10.) Nevertheless, the taxes that are payable according to the regulations of the taxing authorities must be recorded as a liability.

The payment of income taxes does not always coincide with the incurrence of the taxes. In Canada, companies are generally required to make monthly income tax payments, usually based on the taxes paid the previous year, so that the government has a steady flow of cash coming in during the year. The deadline for filing a corporate income tax return is six months after the company's fiscal year end, but the balance of taxes owed for the year must generally be paid within two months of the year end and therefore often has to be estimated. Penalties are imposed if the company significantly underestimates the amount of tax payable.

Exhibit 9-1 contains the current liability section of the balance sheet for Lululemon Athletica Inc. and illustrates many of the current liabilities related to operating activities discussed so far. Lululemon produces and sells athletic apparel for yoga, running, and dance. Note the size of the liabilities for accounts payable (which would be primarily for inventory acquisition costs), accrued liabilities (which would include a variety of expenses that have been incurred but not yet paid), accrued compensation and related expenses (which would include unpaid salaries and wages, fringe benefits, and payroll taxes), and income taxes payable (which would be based on the company's earnings). The liability for unredeemed gift cards will be explained in a later section of this chapter.

Warranty Obligations¹

When companies sell goods or services, there are often either stated or implied guarantees, or warranties, to the buyers. If a product proves to be defective, the company that manufactured or sold it may have to provide warranty services to repair or replace it. Companies sometimes charge extra for warranties; in other cases they provide warranty coverage at no explicit additional charge. Warranties that are sold separately to customers (i.e., those that have an explicit extra charge) are discussed in the following section on unearned revenues; here we deal only with warranties that are provided at no additional charge.

EXHIBIT 9-1  LULULEMON ATHLETICA INC. 2009 ANNUAL REPORT

Although, at the time of the product's sale, the company cannot know how much the cost of the warranty services will ultimately be, it should still estimate and accrue the warranty cost in order to match the expense from the warranty to the revenue from the sale. In other words, to satisfy the matching principle, in each accounting period a warranty expense and a warranty liability must be recognized, based on an estimate of the future warranty costs that will be incurred on sales made that period. If the company has been in business for a long time, this estimate can probably be made fairly easily, based on the history of past warranty claims. For new products and new companies, estimating what the future costs will be may be much more difficult.

As an example of a warranty situation, suppose a home appliance company sells 200 refrigerators in 2010, and that each refrigerator has a two-year warranty against mechanical defects. Although the company buys quality merchandise from its suppliers, it is very likely that within two years of sale some of these refrigerators will require warranty services. After reviewing its record of past warranty services, the company estimates that approximately 6% of the refrigerators it sells require warranty services during the first year following their sale, and another 4% require warranty services during the second year after their sale. It also determines that the average cost to repair a refrigerator under the warranty is $150. Over the two-year period of the warranty, the company therefore expects that it will have to spend about $3,000 (10% of 200 units = 20 units; 20 units @ $150 per unit = $3,000) on warranty services for the refrigerators sold in 2010. Of course, this is just an estimate based on averages; the actual costs may be more, or less, than $3,000. However, experience and knowledge of their merchandise usually enable companies to make reasonably accurate estimates of their future warranty costs.

To record the estimated warranty obligation in the period of the sale, the company would make the following journal entry:

Note that the entire estimated warranty cost is recorded as an expense in the year of sale, regardless of the length of time covered by the warranty. Whether the warranty costs will be incurred over two years (as in this example) or some other time period is irrelevant for determining the expense to be reported on the statement of earnings. On the statement of financial position, the portion of the obligation that is expected to be settled within a year would be reported as a current liability, and any portion that extends beyond one year would be reported as a non-current liability.

If, during 2011 and 2012 our company spent $1,700 and $1,100, respectively, for warranty work on these refrigerators, it would record these expenditures by reducing the warranty liability account, as follows:

In this case, it appears that the company overestimated its warranty costs slightly. It estimated that the costs would total $3,000, but the costs were actually $2,800 ($1,700 + $1,100). As a result, the liability account will have a balance of $200 remaining in it. If this pattern continues for several periods, the company may want to reduce its estimates. However, there will probably be some years when the actual warranty costs are higher than estimated, and in the long run things may average out.

As you can see in the foregoing journal entries, no expense is recorded when actual warranty costs are incurred. Rather, the warranty liability account is debited, to reflect the fact that a portion of the company's obligation has been satisfied.

By estimating its expected future obligation at the same time that it records the sale, the company records the warranty expense in the same accounting period as when the sales revenue is recorded. In this way, the statement of earnings provides a better indication of the profitability of that period's operations. If the company delayed recognizing any expense until it actually incurred the warranty costs, in our example the revenue would be in the 2010 statement of earnings and the expenses would be in the 2011 and 2012 statements of earnings. As a result, the profit reported in 2010 would be overstated. For this reason, if warranty costs are material, companies are required to estimate their expected future warranty obligation, and to record this liability and the related warranty expense at the time of sale.

Warranties thus provide another illustration of the importance of ensuring that the statement of earnings shows a complete picture of the operating results each period, and that the statement of financial position shows the company's true financial position at the end of each period. By recording warranty liabilities, accountants recognize that when goods are sold with warranties companies incur obligations to honour the future claims that will be made.

Unearned Revenues

In many businesses, customers are required to pay deposits or make down payments prior to receiving goods or services. This creates partially executed contracts between buyers and sellers. Because the sellers have not fulfilled their part of the contract, it would be inappropriate for them to recognize revenue at this point. Therefore, sellers t must defer the recognition of revenue from deposits and down payments. These deferrals create liabilities that are known as unearned revenues or deferred revenues.

Businesses that require prepayments show unearned revenues in the liability section of the balance sheet because, by accepting the money in advance, they incur an obligation to provide the related goods or services (or, failing that, to return the money). Magazine and newspaper publishers that sell subscriptions are among these types of businesses. They receive money for subscriptions in advance, and must initially record this as an asset (cash) offset by a liability (unearned revenue). They earn the revenue later, when they deliver the magazines and newspapers. At that time, they reduce the liability account and record the revenue.

Airlines are another example of businesses that receive payments in advance. When a customer pays for a ticket for a future flight, the amount received by the airline must be treated as unearned revenue (a liability) until the flight has been provided; when the flight occurs, the revenue is earned and the liability is eliminated. For example, the current liability section of the balance sheet for WestJet Airlines as at December 31, 2009, included $286,361,000 for Advance Ticket Sales. The accompanying notes stated that “Guest revenues, including the air component of vacation packages, are recognized when air transportation is provided. Tickets sold but not yet used are reported in the consolidated balance sheet as advance ticket sales.”

Gift Certificates and Prepaid Cards

The sale of gift certificates and prepaid cards is a major source of unearned revenue for many businesses. According to accounting standards, gift card revenue is recognized only when the cards are redeemed for goods or services. When a gift certificate or prepaid card is sold, the business records the cash received and an offsetting liability, representing its obligation to provide goods or services equal to the value of the card. Later, when the gift card is used, the liability is eliminated and revenue is recognized.

The popularity of gift cards is having a major effect on the sales patterns of many retail businesses. The November-December holiday shopping season is very important to most retailers. However, much of the money spent on gift cards late in the current year shows up in sales revenues early in the next year, when the gift cards are redeemed. Thus, in terms of revenue recognition, selling gift cards during the holiday shopping period shifts revenues to January and February. In particular, gift card activations (when cards are purchased) drop off sharply after December. In contrast, January redemptions (when gift cards are used to purchase something) are very significant. As a result, the usual drop-off in sales from December to January has moderated. The recognition of December gift card sales as revenues in January has given the start of the new year a significant financial boost, in a time that has traditionally been a slow one for retail businesses.

The following example illustrates the journal entries required to record gift certificates or prepaid cards, and their impact on the financial statements.

In December 2011, a company sells gift cards worth $10,000. Twenty percent of these are redeemed in December, for merchandise with a cost of $1,500. Sixty percent of the cards are redeemed in January 2012, for merchandise with a cost of $5,000. The remaining 20 percent of the cards are still outstanding at the end of January.

The journal entries for December 2011 would be as follows:

The December 31, 2011, statement of financial position would report a liability of $8,000 ($10,000 − $2,000) of unearned revenue related to the outstanding gift cards. The statement of earnings for the month of December would include sales revenue of $2,000 and cost of goods sold of $1,500, for a gross profit of $500 from the gift cards that were redeemed in December.

The journal entries for January 2012 would be as follows:

The January 31, 2012, statement of financial position would report a liability of $2,000 ($10,000 − $2,000 − $6,000) of unearned revenue related to the gift cards that are still outstanding. The statement of earnings for January would include sales revenue of $6,000 and cost of goods sold of $5,000, for a gross profit of $1,000 from the gift cards that were redeemed in January.

The current liabilities section of Lululemon Athletica Inc.'s balance sheet (which was presented in Exhibit 9-1) shows that, even though the company has a January 31 year end and many of its gift cards were probably redeemed in January, Lululemon still has a large liability related to unredeemed gift cards included in its current liabilities.

Customer Rewards or Loyalty Programs

Many businesses have customer loyalty programs to encourage their customers to buy from them. Under these programs, points (or other forms of credits) are awarded to customers when they make purchases, and these points can later be redeemed for free goods or services. Some companies participate in general rewards programs, such as Air Miles, that are operated by independent entities. In other cases, the loyalty programs are specific to particular companies, such as the Optimum rewards program operated by Shoppers Drug Mart.

The accounting issues related to these customer loyalty programs are similar to those for warranties. Traditionally, the usual approach was to estimate the cost of the free goods and services that were expected to be provided in the future, and accrue this as an expense in the period when the sales revenue was recorded. The offsetting credit was to a liability account with a title such as Loyalty Program Obligations. Later, when customers redeemed their points for free goods or services, their cost was debited to this liability account, because the obligation had been satisfied. This process ensured that the cost of providing the rewards was matched against the revenues that were generated when the sales were made. Note that this treatment parallels the way in which warranty obligations (discussed earlier) have traditionally been accounted for.

However, as with warranty obligations, recent standards under IFRS have moved towards measuring loyalty program liabilities as the sales value of the goods or services that will be required to satisfy the reward redemptions, rather than the company's acquisition cost for these goods and services. Thus, if a company estimated that the points awarded in a particular accounting period will be redeemed for goods or services that could have been sold for $4,000, it would record a liability (in the form of unearned revenue) of this amount. If the rewards were later provided at a cost of $3,000, the company would report a profit of $1,000 from the rewards program in the later period's earnings.

Essentially, the new approach to accounting for customer loyalty programs is to treat the original sale as a “bundle” consisting of two parts: the initial goods or services that are provided at that point, plus the additional goods or services that may be provided in the future under the rewards program. In other words, part of the amount that customers pay when they make purchases is deemed to be for the rewards that will be provided later. Accordingly, the selling company should allocate a portion of the sales revenue to the rewards program and treat it as unearned revenue, until the rewards are delivered.

Warranty Sales²

As a final illustration of a situation involving unearned revenues, consider the case of retailers such as Future Shop who sell warranty coverage (either basic or extended warranties) on the products they sell. When customers purchase these warranties, the company has to record the amount received as unearned revenue and carry this as a liability on its statement of financial position, until either the warranty services are provided or the warranty period ends.

Constructive Obligations

In addition to the traditional types of liabilities arising from laws or contracts, IFRS also recognizes a type called a “constructive” liability. Constructive obligations can arise when a company has, through its past or present practices, indicated to other parties that it will accept specific responsibilities, and the other parties reasonably expect it to do so. For example, a company might have a long-standing practice of paying a bonus of 5 percent of employees' annual salaries at the end of each year. Therefore, even though it may not be required by law or contract to pay the 5 percent bonus, the company has created the expectation that it will continue to provide it. As a result of its consistent past actions, the company has a constructive obligation. Consequently, if the bonus has not been paid it would be accrued as a liability.

Current Liabilities Related to Financing Activities

Working Capital Loans and Lines of Credit

Companies need to have sufficient current assets or inflows of cash from operations to pay their debts as they become due. At times the current assets may not be converted into cash quickly enough to meet current debt obligation deadlines. To manage these shortfalls, companies have a few options. For example, they can arrange a working capital loan with a bank. (As discussed earlier in this book, working capital refers to the amount by which a company's current assets exceed its current liabilities.) This type of short-term loan is often guaranteed (secured) by the company's accounts receivable, inventory, or both. As the inventory is sold and money is collected from the accounts receivable, the amounts received are used to pay off the loan.

Loans or other debts are said to be secured whenever specific assets have been pledged to guarantee repayment of the debt. Assets that have been pledged as security for debts are referred to as collateral. If the borrower defaults on a secured debt, the lender has the legal right to have the collateral seized and sold, and the proceeds used to repay the debt. If debts are unsecured, this means that no specific assets have been pledged as collateral to guarantee their repayment; in such cases, the creditors simply rely on the general creditworthiness of the company.

Another way that companies can deal with temporary cash shortages is to arrange a line of credit with a bank. In this case, the bank assesses the company's ability to repay short-term debts and establishes a short-term loan limit that it feels is reasonable. If cheques written by the company exceed its cash balance in the bank, the bank covers the excess by immediately activating the line of credit and establishing a short-term loan. The bank uses subsequent cash deposits by the company to repay the loan. A bank line of credit provides the company with greater flexibility and freedom to take advantage of business opportunities and/or to settle debts.

A company that is using a working capital loan or a line of credit might have a negative cash balance. If so, it must be shown with the current liabilities. For example, at the end of its 2010 fiscal year, Magnotta Winery Corporation had an operating line of credit with a limit of $11,500,000. Of this amount, the company had borrowed $5,249,398 on January 31, 2010, which was down from $5,881,325 a year earlier. These amounts were due on demand, and were reported as bank indebtedness in the current liabilities section of Magnotta's balance sheet. The interest rate applicable to this line of credit was the prime rate—the loan rate that is offered by banks to their best customers—plus 0.875%. (As you may recall from earlier examples, Magnotta Winery has vineyards in Ontario and Chile and produces, imports, exports, and retails beer and spirits, as well as wine and ingredients for making wine).

Short-Term Notes and Interest Payable

Short-term notes payable represent company borrowings that require repayment in the next year or operating cycle. They either carry explicit interest or are structured so that the difference between the original amount received and the amount repaid represents implicit interest. In either case, interest expense should be recognized over the life of these loan agreements.

Of course, every note payable that is recorded by one party (the borrower or debtor) is recorded as a note receivable by the other party to the transaction (the lender or creditor). Accordingly, the treatment of notes payable and interest expense in the following discussion parallels the treatment of notes receivable and interest revenue that was discussed in Chapter 6.

Illustration of a loan with equal monthly payments that include both interest and principal: Assume that a company borrows $10,000 from a bank at 9% on June 30, to be repaid in equal monthly instalments over six months. (This type of loan is called an instalment loan, to indicate that payments are made periodically rather than only at the end of the loan.) The bank determines that the required amount of each monthly payment is $1,710.69. The monthly instalments include reductions of the principal (which is initially $10,000) as well as interest (at the rate of 9% per annum, calculated on the decreasing amount of principal outstanding each month). The following table illustrates how the interest and the reductions of the principal are calculated:

This type of table is called a loan amortization table because it shows how the original amount of the loan is reduced as time passes. The periodic payments on this type of loan are referred to as blended payments, because they contain both interest and principal components. Although the total payment is the same amount each period, the portion of each payment that is consumed by interest is reduced as the principal balance is reduced.

Notice that the total interest on the loan ($264.14) is much less than it would have been if the entire $10,000 debt had been outstanding for six months ($10,000 × 9% × 6/12 = $450). This is because monthly payments were made and large portions of these payments were applied to the principal, which reduced the principal amount owing and made the average loan balance outstanding during the six-month period much less than $10,000.

The journal entries to record this loan and the payments on it are as follows:

As shown in the loan amortization table, the principal balance in the short-term note payable account will gradually be reduced as each monthly payment is made, and should be zero when the final payment is made on December 31.

Illustration of a loan with monthly payments of interest only: To illustrate a different type of loan arrangement, we will now consider the case of a company that takes out a six-month loan for $10,000 at 9% on June 30, but with terms that specify that only the interest on the loan is to be paid each month; the principal is to be repaid as a lump sum on December 31.

Note the key difference between this situation and the previous one: in this case, there are no reductions in the principal of the loan during its life. In this type of situation, a loan amortization table is not necessary, because the principal balance remains the same from the start of the loan on June 30 until it is repaid in full on December 31. Consequently, the amount of interest is the same each month, calculated as $10,000 × 9% × 1/12 = $75.

The journal entries to record this loan and the payments on it are as follows:

We chose to use the account title Short-Term Note Payable for this liability. However, alternatives such as Short-Term Bank Loan are also commonly used.

Illustration of a loan with no explicit interest charge: Another type of loan arrangement would be for a company to borrow $10,000 on June 30 and sign a note promising to repay $10,450 on December 31. In this case, even though there is no mention of interest, the extra $450 that has to be paid is clearly an interest charge. Over the six-month period of the loan, this interest should be recognized at the rate of $75 per month ($450 ÷ 6 months). In essence, this situation is almost the same as the previous one. The only real difference is that none of the interest is paid until the note becomes due.

The journal entries to record this loan and its repayment are as follows:

Notice that although the note payable states an amount of $10,450, it is initially recorded at its principal amount (or present value) of $10,000. The $450 of interest only arises as time passes. Over the term of the loan, the carrying value of the liability increases by $75 per month and reaches its maturity value of $10,450 on December 31, when it is repaid.

Current Portion of Long-Term Debt

When long-term debts (which will be discussed in Chapter 10) come within a year of being due, they must be reclassified as current liabilities. This reclassification enables users to estimate the expected outflow of cash during the following year. Therefore, this liability category, generally known as the current portion of long-term debt, is used for all the debt that was originally long-term but is now within one year, or one operating cycle, of being paid off or retired.

In the case of long-term loans, mortgages, or other debt obligations that require monthly or annual payments, the portion that should be reported as a current liability is the amount of principal and any accrued interest from past periods that will be paid within the next year. Remember that interest for future periods is not recorded until it accrues or is paid.

Exhibit 9-2 shows the current liabilities section of the balance sheet for Shaw Communications Inc. as of August 31, 2009. Shaw is a diversified Canadian communications company that provides cable television, high-speed Internet, digital phone, mobile telecommunications, and satellite direct-to-home services to subscribers. Notice that the exhibit includes some of the current liabilities related to financing activities discussed in this section of the chapter—working capital loans and lines of credit, and current portions of long-term debts—as well as accounts payable and accrued liabilities, income taxes payable, and unearned revenue. More details of Shaw's current liabilities are provided in the notes that accompany the statements, and users should refer to these for a complete picture of the company's current obligations.

EXHIBIT 9-2  SHAW COMMUNICATIONS INC. 2009 ANNUAL REPORT

STATEMENT ANALYSIS CONSIDERATIONS

Current liabilities are, of course, a key component of both the current ratio (i.e., current assets ÷ current liabilities) and the quick ratio (i.e., [current assets − inventories − prepaid expenses] ÷ current liabilities), which were introduced in Chapter 6.

In addition to the current and quick ratios, we can also calculate various turnover ratios related to current liabilities. The most common of these is the accounts payable turnover rate, which is calculated as follows:

The amount of purchases is not usually reported directly in the financial statements. However, the cost of goods sold can be used as a starting point. Making an adjustment for the change in inventories during the period will convert the cost of goods sold to the cost of goods purchased. As you should recall from Chapter 7, Beginning inventory + Purchases − Ending inventory = Cost of goods sold. Rearranging these terms, the formula to calculate the purchases is as follows:

For example, using the financial statements in Appendix A we can calculate H&M's purchases as SEK 40,659 (SEK 38,919 − SEK 8,500 + SEK 10,240). Its accounts payable turnover rate for 2009 can then be calculated as follows:

H&M's accounts payable turnover ratio indicates that its payables were paid off and replaced by new accounts payable 11.1 times during the year. To make this result easier for users to relate to, many analysts convert the accounts payable turnover rate to an average payment period or days to pay ratio. This is done by simply dividing the previous result into 365 days per year. Using H&M's data, this produces the following:

This indicates that, on average, H&M took 32.9 days to pay its accounts payable in 2009. To assess whether this is a good or bad result, we should compare this to the payment period allowed by the company's creditors, to the results from previous years, and/or to the results for other companies in the same industry.

CONTINGENCIES

The term contingent liability (also sometimes referred to as contingent loss) refers to a situation in which a liability is conditional; that is, whether there will be a liability depends on some future event. Under IFRS, contingent liabilities are not recorded in the accounts, but they must be disclosed in the notes to the financial statements if they could have a material impact on the company's financial position.

For example, a contingent liability exists when a company has guaranteed another company's debt.³ This often happens when a subsidiary company takes out a loan and the parent company (the company that owns all or most of the subsidiary's shares) guarantees repayment of the loan. For the parent company, the obligation to repay the loan is a contingent liability because it will only arise if the subsidiary company defaults on the loan; if the subsidiary repays the loan according to its terms, the parent will have no liability. Another kind of contingent liability exists when a company is the defendant in a lawsuit; it may or may not incur a liability, depending on the outcome of the case.

Because of the uncertainty in such situations, guidelines have been developed to distinguish contingent liabilities (which are disclosed in the notes but not recorded in the accounts) from estimated liabilities or provisions (which are recorded in the accounts).

Under IFRS, when there is a contingency a liability should be recorded and reported on the statement of financial position (and a loss recognized and reported on the statement of earnings) if the following criteria are met:

1. It is probable that some future event will result in the company incurring an obligation that will require the use of assets or the performance of a service.
2. The amount of the resulting liability (and loss) can be reasonably estimated.

With respect to point 1, notice that the recognition criterion for assessing the uncertainty of a confirming future event is whether the event's occurrence is considered “probable.” This is generally interpreted to mean simply “more likely than not.” Clearly, this will often be a very subjective assessment and considerable judgement will have to be exercised.

With respect to point 2, notice that if the amount cannot be measured reliably, no liability is recognized. In the past, companies often avoided having to record probable future liabilities on the basis that they could not be reliably estimated. For example, they sometimes argued that the amount of the liability could range anywhere from a few thousand dollars to hundreds of millions of dollars, and that such a wide range of possible outcomes meant that the amount could not be reasonably estimated. However, under IFRS this should be the case only in very rare circumstances, because, when necessary, an “expected value” method is to be used to measure the liability. If a range of possible outcomes is available, this approach assigns weights to each of the possible outcomes according to their associated probabilities.

To illustrate the calculation of the probability-weighted expected value of a liability, consider the following set of estimated possible outcomes and estimated probabilities:

Therefore, in this example, if it is considered probable (more likely than not) that there will be a liability, it would be recorded at its expected value of $577,500.

If either of the two criteria is not met (i.e., if the future event that would confirm the obligation is not considered probable, or if it is not possible to estimate the amount reliably), then the liability is not recorded in the accounts. Rather, it is classified as a contingent liability, which means that the company should provide users with information about it in a note disclosure (unless the potential loss is not significant).

With its headquarters in Montreal and operations in eight Canadian provinces and 16 American states, Canadian National Railway Company has the largest rail network in Canada and the only transcontinental network in North America. The excerpts from Note 17 to CN's 2009 financial statements presented in Exhibit 9-3 provide details of the company's contingencies related to environmental matters, in par D, and guarantees and indemnifications, in part E. Although the exhibit is a long one it includes a discussion of some of the difficulties associated with determining the existence and amount of potential obligations, and provides a good example of how contingent liabilities can be disclosed.

EXHIBIT 9-3  CANADIAN NATIONAL RAILWAY COMPANY 2009 ANNUAL REPORT

Excerpts from Note 17 to Consolidated Financial Statements

As another example of a contingency, the selling of accounts receivable with recourse creates a contingent liability for the selling company⁴ because it may be required to buy back the receivables under the recourse provision if the customers default on their payments. (Refer to Chapter 6 for further discussion of the sale of accounts receivable.) Exhibit 9-4 illustrates how a company disclosed that it had sold accounts receivable to financial institutions and, as a result, had contingent liabilities in the form of limited recourse obligations for delinquent receivables.

EXHIBIT 9-4  CANADA BREAD COMPANY, LIMITED 2009 ANNUAL REPORT

Note 3 to the Consolidated Financial Statements

COMMITMENTS

In the course of business, many companies sign agreements committing them to certain future transactions. These are generally described in the notes to the financial statements as commitments.

A common example in many types of businesses is purchase commitments, which are agreements to purchase items in the future for pre-arranged prices. Some purchase commitments are referred to as take-or-pay contracts, which means that the company must pay for a specified quantity at the specified price, whether it actually takes that much from the supplier or not.

As discussed earlier, a purchase commitment is an example of a mutually unexecuted contract and is therefore not recorded as a liability. The company would, however, discuss it in a note to the financial statements if it thought that the commitment could have a material effect on its future operations. Exhibit 9-5 shows an example of this type of disclosure.

EXHIBIT 9-5  BIG ROCK BREWERY INCOME TRUST 2009 ANNUAL REPORT

Excerpts from Note 13 to the Consolidated Financial Statements

Disclosures regarding purchase commitments such as these are important because they let users know that the company is planning ahead and arranging future contracts at fixed prices for items that it is going to need in its operations. These types of contracts and commitments are often an important part of a company's risk management activities, through which it tries to control the probability and impact of negative events. If prices rise and/or supply shortages occur, the company will benefit from having entered into these commitments in advance. On the other hand, the prices of these items may fall in the marketplace, leaving the company committed to paying prices higher than what would have been paid if no contracts were in place. If this happens, the company will incur losses as a result of having made the purchase commitments. For this reason, any commitments that could have material effects on future operations must be disclosed in the notes to the financial statements.

Also, to enable the users of financial statements to assess risks and estimate future cash flows, companies must disclose any commitments that will require major cash outflows during the next five years. For example, if a company has a long-term loan and a lease contract that commit it to paying significant amounts during the next five years, it must provide schedules of the payments that will be required under these commitments.

Research in Motion, the Canadian company that manufactures the BlackBerry, has such commitments. Exhibit 9-6 presents Note 12 on commitments and contingencies from RIM's 2010 annual report. Notice that part (b) of this note discloses the amounts that the company is committed to pay in each of the next five years under its lease contracts, while part (c) deals with contingencies and describes how RIM handles the uncertainties surrounding intellectual property disputes and legal actions.

EXHIBIT 9-6  RESEARCH IN MOTION INC. 2010 ANNUAL REPORT

SUMMARY

This chapter opened with a description of commonly reported current liabilities. It traced the financial statement impact of accounts payable, wages and related payroll liabilities, income taxes, warranty obligations, unearned revenues (including gift certificates and prepaid cards, customer rewards or loyalty programs, and warranty sales), lines of credit, short-term notes, and the current portions of long-term debts. Items significantly affected by International Financial Reporting Standards were highlighted, including the concept of constructive obligations. It also described some items that can affect the decisions made by users, but that may or may not be reflected on the financial statements, such as loss contingencies and commitments.

In Chapter 10, our attention turns to non-current liabilities, particularly long-term notes and bonds payable, mortgages, pension obligations, lease liabilities, and deferred income taxes.

Additional Practice Problems

ABBREVIATIONS USED

CPP	Canada Pension Plan
EI	Employment Insurance
QPP	Quebec Pension Plan

SYNONYMS

Average payment period Days to pay ratio

Contingent liability Contingent loss

Current portion of long-term debt Long-term debt due within one year

Deferred revenue Unearned revenue

GLOSSARY

Accounts payable turnover A ratio that measures how many times per period a company's accounts payable are paid off and replaced by new accounts payable.

Average payment period The average number of days that a company takes to pay for its credit purchases. Synonym for the days to pay ratio.

Blended payments Loan payments that consist of both interest and principal, with the total amount remaining constant but the portion for interest becoming smaller as each payment is made.

Collateral An asset that has been pledged as security for a debt. If the borrower defaults on the debt, the lender can have the collateral seized and sold, with the proceeds used to repay the debt.

Commitments Obligations that a company has undertaken which do not yet meet the recognition criteria for liabilities. Significant commitments are disclosed in the notes to the financial statements.

Constructive obligations Liabilities that do not arise from legal or contractual obligations but from a company's past or present practices, which have indicated to other parties that it will accept specific responsibilities and the other parties reasonably expect it to do so.

Contingencies Events or transactions whose effects on the financial statements are conditional on future events.

Contingent liability A liability that is not recorded in the accounts, because it depends on a future event that is not considered probable and/or it cannot be estimated reliably. Significant contingent liabilities are disclosed in the notes.

Contingent loss Synonym for contingent liability.

Current portion of long-term debt The portion of long-term debt that is due within one year (or one operating cycle).

Days to pay ratio The average number of days that a company takes to pay its accounts payable. Synonym for the average payment period ratio.

Deferred revenues Cash receipts, from customers, that have not yet met the criteria for revenue recognition. Synonym for unearned revenues.

Instalment loan A type of loan in which payments (including both interest and a portion of the principal) are made periodically, rather than only at the end of the loan.

Liability A duty, responsibility, or obligation that imposes an enforceable economic burden on an entity.

Line of credit A borrowing arrangement with a bank, based on a pre-authorized credit limit that allows a company to write cheques for amounts that exceed the balance of cash in its bank account.

Loan amortization table A table that shows how the original amount of a loan is reduced over time, as a result of interest being added and payments being deducted.

Mutually unexecuted contract A contract between two entities in which neither entity has performed its part of the agreement.

Non-financial liabilities Liabilities that are expected to be settled through the delivery of goods or the performance of services, rather than the payment of cash.

Partially executed contract A contract between two entities in which one or both of the parties has performed a portion of its part of the agreement.

Present value The value today of an amount or series of amounts to be received or paid in the future. See also time value of money.

Prime rate The interest rate that banks charge their best customers.

Provisions A term used in IFKS to refer to liabilities where there is uncertainty about the timing or the amount of the future expenditures.

Purchase commitment A contract between two entities in which one entity agrees to buy goods or services from another entity, usually at predetermined prices.

Risk management The processes through which organizations identify, assess, and prioritize risks and coordinate the application of resources to monitor and control the probability and impact of negative events.

Secured Loans or other debts are said to be secured when specific assets have been pledged to guarantee repayment of the debt.

Take-or-pay contract A contract in which the buyer must pay for a minimum quantity, whether delivery of the goods is taken or not.

Time value of money The concept that a specified sum of money is worth more if it is paid or received now rather that later (because money received now can be invested to grow to a larger amount later). More generally stated, the value of a specified amount of money decreases as the time until it is paid or received increases.

Unearned revenues Cash receipts from customers that have been received in advance and not yet met the criteria for revenue recognition. Synonym for deferred revenues.

Unsecured Loans or other debts are said to be unsecured when no specific assets have been pledged to guarantee repayment of the debt.

Working capital loan A short-term loan, often on a demand basis, that is arranged with a bank to cover a company's short-term cash shortages.

ASSIGNMENT MATERIAL

Assessing Your Recall

9-1 List three essential characteristics of a liability.

9-2 Explain what a mutually unexecuted contract is and how it is accounted for.

9-3 Describe, in general terms, the appropriate valuation methods for current and non-current liabilities.

9-4 Explain the meaning of the terms “gross pay” and “net pay” in regard to employees' earnings.

9-5 Why do employers often object when the government changes the rates for CPP, QPP, or EI?

9-6 Explain the meaning of the term “payroll taxes.”

9-7 Explain why warranty expenses and the actual costs incurred with respect to warranties often do not occur in the same period.

9-8 If a product is sold at the beginning of year 1 with a three-year warranty, should the expected cost of honouring the warranty be spread over years 1, 2, and 3, or recognized entirely in year 1? Explain, with reference to the accounting principle(s) involved.

9-9 Describe the nature of unearned revenues and provide an example.

9-10 Explain why companies record a liability when they sell gift cards.

9-11 Explain the meaning of the term “non-financial liabilities” as it is used in IFKS.

9-12 Explain what a constructive liability is and how it differs from other liabilities.

9-13 Outline what a line of credit is and how it operates.

9-14 Explain what an instalment loan is and how interest expense is calculated for such a loan.

9-15 If a company borrowed $10,000 on September 1 of the current year and signed a note promising to repay $10,600 on August 31 of next year, explain how the interest expense would be determined for this year and next year.

9-16 What is meant by the “current portion of long-term debt”? Why is it recorded with the current liabilities?

9-17 Outline the conditions under which loss/liability contingencies would be recorded in the accounts or disclosed in the notes to the financial statements.

9-18 Explain the meaning of the term “provisions” as it is used in IFRS.

9-19 Describe the circumstances that would require commitments to be recognized in the financial statements.

Applying Your Knowledge

9-20 (Various current liabilities)

Joan's Golf Shop had the following transactions involving current liabilities in its first year of operations:

1. The company ordered golf equipment from suppliers for $546,000, on credit. It paid $505,000 to suppliers during the year.
2. The shop has seven employees, who earned gross wages of $230,000 for the year. From this amount, Joan deducted 22% for income taxes, 5% for Canada Pension Plan deductions, and 2% for Employment Insurance contributions before giving the cheques to her staff. As an employer, she was also required to make additional contributions of 5% for Canada Pension Plan and 2.8% for Employment Insurance. Eleven-twelfths of the amounts due to the government (i.e., all except for the last month) were paid before the end of the year.
3. Joan gives her customers a one-year warranty on golf clubs. She estimated that warranty costs would total 2% of sales. Sales of golf clubs for the year were $1,100,000. During the year, she spent $13,000 to replace faulty golf clubs under the warranty.
4. Some customers order very expensive, custom-made golf clubs. In these cases, Joan requires them to pay a deposit of 50% of the selling price when the order is placed. During the year, deposits totalling $20,000 were received for custom orders. None of these orders have been delivered yet.

Required:

1. Prepare journal entries to record the transactions.
2. Prepare the current liabilities section of the balance sheet as it would appear at the end of the year.

9-21 (Various current liabilities)

Shamsud Ltd. operates on a calendar-year basis. At the beginning of December 2011, the company had the following current liabilities on its books:

Accounts payable	$85,000
Rent payable	10,000
Obligations under warranties	12,000
Unearned revenue	14,000

In December, the following events occurred:

1. Shamsud purchased a new computer system on account at a cost of $28,000, payable on January 15, 2012. In addition to this, $4,000 was paid in cash to have the new system installed and customized to the company's requirements.
2. The company purchased inventory for $93,000 on account and made payments of $86,000 to its suppliers.
3. The rent that was payable at the beginning of December represented the payment that should have been made in November. In December, Shamsud paid the past rent owed, as well as the rent for December and January.
4. By December 31, the company had earned $5,000 of the revenue that was received in advance from customers.
5. Shamsud's employees are paid a total of $2,000 per day. Three work days elapsed between the last payday and the end of the fiscal year. (Ignore deductions for income tax, CPP, and EI.)
6. The company's products are sold with a two-year warranty. Shamsud estimates its warranty expense for the year (not previously recorded) as $16,000. During December, it paid $1,200 in warranty claims.
7. The company borrowed $60,000 from the bank on December 15 at an interest rate of 8%. The principal and interest are due six months from the date of the loan.
8. Since the beginning of 2011, Shamsud has had a five-year note payable of $125,000 outstanding. The note requires that annual interest payments at 7% be made, and that $25,000 of the principal be repaid each January 1.

Required:

1. Prepare the journal entries to record the December transactions and adjustments. (Ignore the amounts that the company pays for its share of CPP and EI.)
2. Prepare the current liability section of Shamsud's balance sheet on December 31, 2011.
3. Explain your treatment of the five-year note payable.

9-22 (Various current liabilities)

Answer each of the following questions related to various short-term liabilities:

1. On September 1, 2011, a company borrowed $100,000 from its bank and signed a nine-month note with 8% interest. The principal and interest on the loan are to be paid when the note matures. What is the total amount related to this loan that should be reported under current liabilities on the company's December 31, 2011, balance sheet?
2. The balance in a company's long-term mortgage payable account on December 31, 2011, is $150,000. This is to be repaid at the rate of $25,000 per year for the next six years. How should this liability be reported on the company's balance sheet on December 31, 2011?
3. During the spring and summer of 2011, the Prairie Predators hockey team sold 2,000 season tickets for the fall 2011–winter 2012 hockey season. Each of the season tickets was sold for $500 and covered 20 games, with 8 to be played in the fall and 12 in the winter. What is the effect on the team's financial statements when the season tickets are sold? What amount of liability (if any) related to the season tickets should be reported on the team's December 31, 2011, balance sheet?
4. Bathurst Beverages collects cash deposits on its returnable bottles and other containers. Past experience indicates that virtually all the bottles and containers will be returned and the deposits refunded. During the current year, the company received $150,000 in such deposits and it disbursed $140,000 for bottles and other containers that were returned. How would this information be reflected in the year-end balance sheet for Bathurst Beverages?
5. During the current year, a company sold 10,000 units of a product that was covered by a two-year warranty. Past experience indicates that approximately 3% of the units sold will require warranty repairs, at an average cost of $50 per unit. The actual costs incurred during the year for repairs under the warranty totalled $7,000. What amount of liability (if any) should be reported on the company's balance sheet at the end of the current year?
6. Shortly before its fiscal year end, a company lost a lawsuit and had damages of $200,000 awarded against it. However, it said that it will appeal the decision in the new year. Its lawyers are confident that the lower court's decision will be reversed. How should this situation be reported in the year-end financial statements? Explain your reasoning.

9-23 (Warranty obligations)

The Athletic Accountant Company produces exercise equipment designed for accountants. Its main product, the Pencil-Pusher Push-Up Platform, is sold with a three-year warranty against defects. The company expects that 1% of the units sold will prove to be defective in the first year after they are sold, 2% will prove to be defective in the second year, and 3% will prove to be defective in the third year. The average cost to repair or replace a defective unit under the warranty is expected to be $60.

The company's sales and warranty costs incurred in its first three years were as follows:

Required:

1. Calculate the amount that should have appeared in the warranty obligation (liability) account at the end of 2009.
2. Calculate the amount of warranty expense that should have been recognized in 2010.
3. Considering the costs incurred to the end of 2011, do you think the company's estimates regarding the warranty costs were too high, too low, or just about right? Explain your reasoning.

9-24 (Two types of warranties)

Computers Galore Ltd. sells computers, computer accessories, and software. On its computer sales, the company provides a one-month warranty that is included in the cost of the computer. Claims under the warranties vary from replacing defective parts to providing customers with new computers if repairs cannot be made. During 2011, the estimated cost related to the one-month warranties was $40,000, of which $36,000 had been incurred before year end.

For an additional charge of $100, Computers Galore also offers extended warranty coverage for two years on its computers. This amount is expected to cover the costs associated with the extended warranties. During 2011, Computers Galore sold 800 two-year warranties. The costs incurred during the year for repairs and replacements under these warranties amounted to $31,000.

Required:

1. Prepare journal entries to record the warranty transactions for 2011.
2. Should Computers Galore classify its warranty obligations as current or non-current? Explain.
3. If the actual costs incurred by the company under the extended warranties are less than the amount charged for them, how should the company account for the difference?

9-25 (Revenues and current liabilities)

University Survival Magazine is a small company run by two enterprising university students. They publish an issue of the magazine once a month from September through April. The magazine reports on various university activities and provides information such as how to get the best concert tickets, where the best pizza is sold for the best price, where the good study spots are located, and how to get library personnel to help you with your research assignments.

The magazine is sold either on a prepaid subscription basis for $12.00 for all eight issues, or for $2.00 per issue. During September, 2,000 subscriptions were sold. Up to the end of December, a total of 12,000 single copies were sold.

The owners also pre-sell advertising space in the magazine to local businesses that focus on the student market. During July and August, they signed up several businesses and collected $20,000 in advertising revenues. The advertisements are to be included in all eight issues of the magazine.

The cost of printing and distributing the first four issues of the magazine was $57,000, of which $46,000 was paid by the end of December. Miscellaneous other expenses totalling $2,000 were incurred and paid in cash.

Required:

1. Journalize all the transactions to the end of December.
2. Prepare any necessary adjusting entries on December 31.
3. Prepare a simple statement of earnings for the magazine, for the period from July to December.
4. Calculate the balance in the magazine's cash account on December 31.
5. Write a brief memo to the owners that explains why their net earnings are less than the net cash generated by their operations.

9-26 (Gift card sales and redemptions)

During the month of December, Emile's Electronics sells $7,000 of gift cards. In January, $5,000 of these cards are redeemed for merchandise with a cost of $3,000. In February, a further $1,500 of these cards are redeemed for merchandise with a cost of $1,000. The company uses a perpetual inventory system.

Required:

1. Prepare journal entries to record the transactions for December, January, and February.
2. How much income (if any) was earned in each of these months?
3. What liability (if any) would appear on the company's statement of financial position at the end of each of these months?

9-27 (Short-term note with explicit interest added)

On April 30, 2011, a company borrows $50,000 from its bank and signs a promissory note to repay it in 18 months plus interest of 8% per year. Although no principal payments are to be made until the note matures in 18 months, the interest on the note is to be paid every 6 months. The company's fiscal year end is December 31.

Required:

1. Give the journal entries that would be made in 2011 to record the issuance of the note on April 30 and the first interest payment on October 31.
2. Would an adjusting entry be required on December 31, 2011, related to this note? If so, give the entry.
3. How much interest expense would be reported on the company's statement of earnings for the year ended December 31, 2011?
4. What liabilities related to this loan would be reported on the company's December 31, 2011, statement of financial position? Specify the accounts, amounts, and how they would be classified.
5. Give the journal entries that would be made in 2012 to record the second interest payment on April 30, and the third interest payment and repayment of the principal when the note matures on October 31.
6. How much interest expense would be reported on the company's statement of earnings for the year ended December 31, 2012?

9-28 (Short-term note with no explicit interest)

On August 31, 2011, a company borrows $50,000 from its bank and signs a note promising to repay $53,600 in one year. There is no mention of interest in the loan agreement. The company's fiscal year end is December 31.

Required:

1. Give the journal entry to record the issuance of the note on August 31, 2011.
2. Would an adjusting entry be required on December 31, 2011, related to this note? If so, give the entry.
3. How much interest expense (if any) would be reported on the company's statement of earnings for the year ended December 31, 2012?
4. Give the journal entries to record the repayment of the loan when the note matures on August 31, 2012.

9-29 (Short-term note with equal blended payments)

On October 31, 2011, a company borrows $50,000 from its bank for five months at an annual interest rate of 8%. The loan agreement specifies that it is to be repaid in five equal monthly instalments, and the bank calculates the required payments to be $10,200.89 per month. The company's fiscal year end is December 31.

Required:

1. Prepare an amortization table for this loan, similar to the one shown on page 597.
2. Give the journal entries that would be made in 2011 to record the issuance of the note on October 31 and the first two payments on November 30 and December 31.
3. What is the amount of the liability related to this loan that would be reported on the company's December 31, 2011, statement of financial position?

9-30 (Assessing a contingency)

On April 1, 2010, while shopping for new furniture for her home, a world-renowned pianist, Mia Thorne, tripped on an electrical cable on the showroom floor and broke her wrist. On June 10, 2010, Ms. Thorne sued the furniture store for $5 million. The case came to trial on September 13, 2010, and the court reached a decision on December 23, 2010, finding the store liable and awarding Ms. Thorne the sum of $1.5 million.

Dissatisfied with the first judgement, the furniture store appealed to a higher court on February 3, 2011. The appeal court heard the case beginning on July 18, 2011. On November 25, 2011, the store was again found liable. In this judgement, Ms. Thorne was awarded $2.5 million in damages; however, the furniture store was given three years to pay.

On January 15, 2012, the store negotiated a reduced amount with Ms. Thorne in return for immediate payment, and paid her $2 million in full settlement of the case.

Required:

Review the events in the case and identify the various dates on which a loss and a liability might be recognized. For each of these dates, refer to the criteria for contingent liability and full liability recognition and recommend whether disclosure through a note to the financial statements or a journal entry would be most appropriate, as well as the amount (if any) that should be reported. The company's year end is December 31.

User Perspective Problems

9-31 (Effects of changes in CPP and EI rates)

Suppose you are the general manager of a company with approximately 100 employees and the government has just announced its new rates for contributions to the Canada Pension Plan and Employment Insurance. With respect to employee contributions, assume that the CPP rate is increasing from 5% to 5.5% and the EI rate is increasing from 1.5% to 2%. Also assume that the company's required contribution for CPP is rising from being equal to the employees' contributions to being 1.1 times the employees' contributions, and the company's contribution for EI is increasing from being 1.4 times the employees' contributions to being 1.5 times the employees' contributions.

Required:

1. Assuming that gross wages amount to $6 million per year, calculate the financial impact that these changes will have on (1) the employees' net pay, and (2) the company's payroll costs.
2. Suggest some actions that the company could take to reduce the impact of these rate changes.

9-32 (Accounting for customer loyalty program)

Suppose that you are the manager of a chain of coffee shops and you are planning to launch a loyalty program that will give one free coffee to customers who buy 10 cups of coffee. Customers will be given an electronic “Coffee Club” card, which will be swiped each time they make a purchase. Your computer system will keep track of how many cups each customer has purchased and will automatically award them a free cup when they have purchased 10.

Discuss the income measurement and liability recognition issues that are presented by this type of customer loyalty program. Your answer should explain how and when the revenues associated with the free cups of coffee should be reported. It should also outline some of the issues that will make it difficult to estimate the amount of the liability for future free coffees arising from current sales.

9-33 (Contingencies and investment decisions)

Suppose that you have been asked by your employer to evaluate the potential purchase of another company. The company has been in the chemical business for more than 60 years and has production and distribution facilities in Alberta, Ontario, Texas, and Mexico. Because of the nature of the chemical industry, the company must recognize the possibility of environmental problems related to the manufacture and transportation of its products.

Required:

1. Explain how this issue might affect your evaluation of the potential purchase.
2. Describe the disclosures that you might find in the company's financial statements related to environmental liabilities, and what additional information you would like to have in assessing its liabilities.

9-34 (Commitments and disclosure issues)

Suppose that you are the sales manager for a construction company and you are responsible for securing contracts. As part of the negotiations to construct a new production facility for a customer, you attached a “sweetener” to the contract in the form of an agreement to supply raw materials to the customer at a fixed price over an extended period of time. The price specified in the agreement is the materials' fair market value at the time the construction contract was signed.

Required:

1. What does the accounting department need to know about the “sweetener” to appropriately account for this agreement?
2. Should the financial statements report this transaction? If so, how?
3. Under what circumstances might your answer to part “b” change?
4. What should be disclosed to the shareholders about this agreement?

Financial Analysis Assignments

Reading and Interpreting Published Financial Statements

9-35 (Presentation of liabilities for a financial services company)

Credit Union Central of British Columbia is the primary financial facility and trade association for the independent credit unions that serve the province. Comparative consolidated balance sheets from its 2009 annual report are presented in Exhibit 9-7.

Required:

1. Notice that Credit Union Central of British Columbia has an item called “loans” listed among its assets. Usually, accounts called “loans” are liabilities. Explain the nature of this item and why it is in the assets section of the balance sheet.
2. Notice that there is an item called “deposits” listed among the liabilities. Explain how a liability arises related to deposits.
3. Like many companies in the financial services industry, Credit Union Central of British Columbia does not distinguish between current and non-current liabilities on its balance sheets. Why do you think this is?

EXHIBIT 9-7  CREDIT UNION CENTRAL OF BRITISH COLUMBIA 2009 ANNUAL REPORT

9-36 (Interest rates and security)

As mentioned in this chapter, Magnotta Winery Corporation has an operating line of credit. Note 4 to the financial statements in Magnotta's 2010 annual report discusses the line of credit:

Required:

1. What does it mean to have an operating line of credit of $11,500,000 available? What kind of institution is the line of credit likely with?
2. The information regarding the interest rate on Magnotta's line of credit refers to “bank prime.” What does this term mean?
3. Magnotta's line of credit bears interest at bank prime plus 0.875% in 2010, compared to bank prime plus 0.250% in 2009. What can you infer from this about the lender's assessment of the company's creditworthiness in 2010 compared to 2009?
4. Is Magnotta's line of credit secured or unsecured? Explain what this means and why a company might prefer to have its debt secured.

9-37 (Line of credit and contingent liability)

As mentioned in the chapter, Research in Motion Inc. (RIM) is the Canadian company that developed the famous BlackBerry communications device. To answer the questions that follow, refer to Note 12 from RIM's 2010 financial statements, which appears in Exhibit 9-6 on pages 604–605.

Required:

1. Part (a) of the note describes a demand credit facility. What does RIM use the credit facility for? As at the end of its 2010 fiscal year, what portion of this line of credit had the company used?
2. The demand credit facility is described as unsecured. What does this mean? Would the company be able to get a lower interest rate if its line of credit was secured? Explain.
3. Part (c) of the note describes RIM's involvement in various legal events. For the settlement of the litigation with Vista, RIM expensed $163.8 million. Had this amount been accrued as a liability in the company's previous financial statements? Explain your answer.
4. As a result of the Vista settlement, what amount did RIM record as an intangible asset? Does it seem reasonable that RIM would record some of the costs of a patent lawsuit as an intangible asset? (If you need to review intangible assets, refer back to Chapter 8).

9-38 (Warranties)

As you are probably aware, Research in Motion Inc. (RIM) is the Canadian company that developed the BlackBerry communications device. Note 13 to RIM's 2010 financial statements, which appears in Exhibit 9-8, along with the revenue figures from the income statement:

EXHIBIT 9-8  RESEARCH IN MOTION INC. 2010 ANNUAL REPORT

Required:

1. Based on the note, how much was the warranty expense that was originally recorded in fiscal 2010? How much was the liability on the balance sheet at the end of the same fiscal year?
2. Warranty obligations are based on estimates, and when management revises the estimate they adjust the current year's expense. What was the effect on KIM's warranty expense and the warranty liability as a result of the changes in estimates made in fiscal 2010 and in 2009?
3. Calculate the ratio of the warranty expense to the revenue for each of the three years presented. Assume that the warranties are only related to revenues generated from devices and not from services provided, and ignore the change in estimates in determining the expense. Comment on your findings.
4. Explain how it would be possible for RIM's management to manage its earnings using warranty estimates.

9-39 (Contingent liabilities)

Rogers Communications Inc. provides cell phone and cable access to consumers, operates radio and television stations, publishes consumer magazines and professional publications, and owns the Toronto Blue Jays baseball club. Details of Rogers' contingent liabilities are shown in Exhibit 9-9, which presents two portions of Note 24 to its 2009 financial statements.

EXHIBIT 9-9  ROGERS COMMUNICATIONS INC. 2009 ANNUAL REPORT

Excerpt from Note 24 to the Consolidated Financial Statements

Required:

1. Summarize the series of events related to the Part II fees described in part (A) to the note. When were amounts expensed or recorded as liabilities, and when were amounts reversed? What caused Kogers to record the Part II fees as expenses in some periods and not record them in other periods? Was there good matching of the expenses with the revenues that gave rise to them throughout the period from 2003 to 2009? Explain.
2. For the lawsuit related to FIDO described in part (E), do you think Kogers accrued an estimated liability for the lawsuit between 2004 and 2009? Support your answer.

9-40 (Loss contingency and liability disclosures)

In May 2010, a powerful blowout and deadly explosion occurred on an oil platform in the Gulf of Mexico owned by British Petroleum plc (BP), resulting in a massive oil spill. With the likelihood that rich fishing grounds, hundreds of kilometres of shoreline, and vital wildlife breeding areas would be severely contaminated, the potential cost of the containment and cleanup work was enormous. In addition to the physical restoration costs, there was the possibility that the livelihoods of thousands of people—from shrimp-boat operators to beach-resort workers—would be disrupted for years to come. At the time of writing, lawsuits against BP totalling billions of dollars were being threatened.

Required:

Review BP's group/consolidated financial reports issued from June 30, 2010, onward and prepare a summary of the company's handling of the liability issues related to this incident. (Hint: Your review should include management's comments on these issues, as well as the financial statements and accompanying notes for the BP group.)

9-41 (Commitments)

Headquartered in Quebec, RONA Inc. operates approximately 700 stores of various sizes and formats across Canada and is the largest Canadian distributor and retailer of hardware, home renovation, and gardening products. Note 19 accompanying KONA's 2009 financial statements provides details of its major guarantees, commitments, and contingencies. Portions of the note are presented below (amounts in thousands of dollars).

Required:

1. As at the date of the financial statements (December 31, 2009), did KONA have a liability related to its Olympic and Paralympic commitment? Explain why or why not.
2. Did the information provided in this note have to be disclosed to the readers of the financial statements? Explain your reasoning.

9-42 (Financial statement analysis)

Marks and Spencer is one of the United Kingdom's largest retailers, with over 600 stores in the U.K. and another 300 located internationally, selling clothing, home products, and food. The data in Exhibit 9-10 are excerpts from the 2009 consolidated income statement, balance sheet, and notes of Marks and Spencer Group plc.

EXHIBIT 9-10A  MARKS AND SPENCER GROUP PLC 2009 ANNUAL REPORT

EXHIBIT 9-10B  MARKS AND SPENCER GROUP PLC 2009 ANNUAL REPORT

Required:

1. Calculate the accounts payable turnover rate for Marks and Spencer for 2008 and 2009. Use the year-end trade payables in your calculations.
2. If you had only used the information available on the financial statements and not the information in the notes, how would your answer to the preceding part have differed?
3. Calculate the current ratio and quick ratio for Marks and Spencer for 2008 and 2009. (Refer to Chapter 6 if you need to review these ratios.)
4. Comment on Marks and Spencer's ability to meet its short-term obligations in 2008 and 2009.
5. Finance costs include interest expense on both current and long-term borrowings. What percentage of revenues did Marks and Spencer spend on finance costs in 2008 and 2009? Explain why you would, or would not, expect interest expense to be a relatively constant proportion of revenues.

Beyond the Book

9-43 (Examine financial statement disclosures)

Choose a company as directed by your instructor and do the following:

1. Prepare an analysis of the current liability accounts by listing the beginning and ending amounts in each of these accounts and calculating the net change, in both dollar and percentage terms, for the most recent year. If the company you have selected does not prepare a classified balance sheet, you will need to determine which liabilities are current.
2. If any account balance changed by more than 10 percent during the year, try to give an explanation for this change. (Hint: Check the notes accompanying the financial statements and the Management Discussion and Analysis section of the annual report.)
3. What percentage of the company's total assets was financed by current liabilities? Did this percentage change significantly during the year?
4. Does the company have any significant estimated liabilities, such as warranties? If so, read any notes discussing these items and summarize the nature of these liabilities.
5. Does the company have unearned revenues? If so, read any notes discussing them and explain the nature of these liabilities.
6. Does the company have any significant contingencies or commitments? Read any related notes and then write a short summary of each significant item. For the contingencies, are you aware of anything that has happened related to these contingencies since the financial statements were issued? If so, give a brief description.

9-44 (Determine current payroll taxes)

Check with employers, an accounting firm, or the Chamber of Commerce and determine the main components of payroll taxes for the province or territory where you are currently located. Also, check the Canada Revenue Agency website and find the current rates for the Canada/Quebec Pension Plan and Employment Insurance, for both deductions from employees and contributions from employers.

Cases

9-45 Greenway Medical Equipment Corporation

At a recent meeting of the board of directors of Greenway Medical Equipment Corporation, the company's chief financial officer, Robert Ables, presented a draft set of financial statements for the year. It is Greenway's corporate policy that the directors be given an opportunity to review the financial statements before they are finalized.

Following the meeting, Mr. Ables received a memo from Dr. Clarise Locklier that included questions about the draft financial statements. Dr. Locklier is a relatively new member of the board of directors and is not familiar with some of the accounting terms and concepts used in the statements. Before voting on approval of the financial statements at the next board meeting, she has several questions she would like to have answered.

Required:

As Kobert Ables, prepare a memo to Dr. Locklier addressing her concerns.

9-46 Hanson Consulting

Jenny Shea is renegotiating her contract with her employer, Hanson Consulting. Jenny knows it is important that she negotiate a good contract, because the amount of her raise will become a benchmark for the raises to be received by Hanson's 14 other consultants. Currently, Jenny and the other consultants are receiving payroll transfers into their personal bank accounts averaging $4,000 per month.

Under her existing contract, Jenny is allowed to review Hanson's annual financial statements. She is puzzled when she sees that Hanson is reporting over $900,000 in consulting salaries on its annual statement of earnings, because she knows that she and the other consultants are paid a total of $720,000 per year (i.e., 15 consultants × $4,000 per month × 12 months). Jenny approaches you, the company controller, to see why the consulting salaries on the statement of earnings are higher than the amounts paid to the employees. She suspects that the company may have posted other expenses to the consulting salaries account, in order to improve its bargaining position for the contract negotiations.

Required:

Explain to Jenny why the company's payroll costs are significantly higher than the net amounts being received by the employees.

9-47 Slip-n-Slide Water Park

It is July 31 and the Slip-n-Slide Water Park has just completed its first three months of operations. The company's owners, Kelly and Derek Neil, are very pleased with the results of operations and are trying to prepare the company's first set of financial statements. You have been controller for a local firm for several years and are good friends with Kelly and Derek, so the couple approaches you with some questions about how certain items should be recorded in their financial statements.

Kelly:	To promote the park and encourage people to bring their kids to it, we gave away 1,000 coupons for free ice cream cones at our canteen, to be redeemed any time during the summer. We usually charge $1.50 for an ice cream, but the cost is only $0.50 per cone. Two hundred of these coupons have been redeemed already. What should we report about the coupons that have been redeemed, and do we need to report anything about the 800 coupons that haven't been used?
Derek:	I can figure out how to record most revenues and expenses, but I don't know how to treat the revenues associated with the 300 season passes that we sold in May and June. They were sold for $60 each and are good for June, July, and August. Holders of season passes have unlimited access to the park for these three months.
Kelly:	The other problem we have is that we just took out a $60,000 bank loan. The 10-year loan agreement requires us to repay $500 of the principal of the loan each month, plus interest at the rate of 8%. Since we'll be making payments on this loan in the next year, I think we should record the $60,000 as a current liability; but Derek thinks it should be recorded as a long-term liability, since it will be 10 years before it is fully repaid.

Required:

Provide the owners with advice on how each of these items should be recorded in the July 31 financial statements. Be sure to explain why they should report the items as you recommend.

9-48 Altabet Company

Altabet Company is completing its financial statements for the year ended April 30, 2011. Janet Kramer, Altabet's controller, is reviewing the company's legal correspondence and trying to decide which, if any, of the contingencies facing the company need to be accrued and reported in the financial statements. During her review, Ms. Kramer identified three contingencies:

1. In July 2009, Jeff Altabet, a son of the company's owner, needed to borrow $400,000. He negotiated with a bank for a five-year loan requiring monthly payments of principal and interest. Because he had just graduated and had no credit history, the company guaranteed the note, stating that if Jeff failed to make three consecutive payments Altabet would repay the loan in full. Jeff has invested the money in a business venture that is turning out to be very profitable. He has made every required payment on the note thus far, and expects to be able to repay the remaining balance of $200,000 within the next year. As at April 30, 2011, Ms. Kramer still considers the balance of the loan to be significant.
2. In October 2010, the company was sued for breach of contract concerning the sale of some equipment to a local manufacturer. The manufacturer claims that because Altabet did not deliver the equipment in the period specified by the contract, the manufacturer lost profits of $50,000. Correspondence with Altabet's lawyer indicates that there was no breach of contract, because the manufacturer was late in making the required advance payment and therefore Altabet was justified in delaying the delivery of the equipment. The lawyer feels that this is a nuisance suit and believes there is little possibility of the manufacturer being successful. Ms. Kramer does not consider the potential loss to be significant.
3. In January 2011, Terry Chambers fell on some ice in Altabet's parking lot. As a result of the fall, Ms. Chambers suffered a concussion and a broken arm that required a two-day hospital stay. She is suing Altabet for $600,000 to cover her medical bills, loss of income, and personal suffering. Altabet's lawyer feels that the company will probably lose the suit and has strongly advised it to settle out of court. On April 25, 2011, Altabet instructed its lawyer to offer Ms. Chambers a settlement of $300,000. Although she has not yet responded to the company's offer, the lawyer believes it is a reasonable offer and is hopeful that Ms. Chambers will accept it.

Required:

With reference to the criteria for reporting contingent liabilities, discuss the appropriate treatment for each of the above contingencies with respect to the April 30, 2011, financial statements of Altabet Company.

Critical Thinking Questions

9-49 (Revenue recognition/expense accrual and income measurement)

Software Solutions produces inventory-tracking and supply-chain management software that it sells to large commercial clients. Its main software packages sell for an average of $130,000 each and require the company to customize the programs to suit each buyer's organization and operations. There is no additional charge for this customization service, as it is included in the initial selling price.

The customization work is done by a special team of employees, usually takes several months to complete, and involves significant costs for Software Solutions, averaging $25,000 per sale. If the buyers had to pay for this customization work, the normal charge would average $40,000 per sale.

Aside from the customization work, the company's cost for each software package sold averages $50,000.

Required:

1. Discuss appropriate accounting treatments for handling the income measurement issues that arise in this type of situation. Describe at least two alternative approaches that could be taken.
2. Indicate what approach would be appropriate in each of the following situations:
   1. The company wants to treat the software customization unit as a “cost centre.” In other words, the customization team is expected to control its costs, but not to generate a profit. (Hint: Under this approach, no revenues are attributed to the customization work.)
   2. The company wants to treat the software customization unit as a “profit centre.” In other words, the customization work is viewed as a profit-generating line of business, separate from the software sales unit. (Hint: Under this approach, a portion of the revenues are attributed to the customization work.)

9-50 (Recognition and disclosure of contingent liabilities)

One of the issues discussed in this chapter is the financial statement recognition and disclosure of contingent liabilities, such as the potential claims associated with litigation and environmental obligations. Loss and liability recognition is dependent on whether it is likely that an asset has been impaired or a liability has been incurred, and the degree to which the loss can be reasonably estimated. Evaluating whether these conditions exist is often a matter of judgement by management and auditors, perhaps more so than with any other issue of recognition or disclosure. Research has shown that reliance on judgement can lead to significant differences among companies, regarding whether and how contingencies are disclosed.

In today's environmentally conscious world, regulatory bodies are making more demands on resource companies to be environmentally responsible. For example, companies involved in mineral or petroleum exploration and development are often required to provide for the cleanup and restoration of resource sites. A review of the annual reports of resource companies reveals that some of these companies report liabilities on their balance sheets in anticipation of these future events, some of these companies disclose contingent liabilities in the notes to their financial statements, and some do or say nothing about these future costs.

Required:

In a brief essay, discuss the criteria that companies should use when deciding on the type of disclosure that is appropriate in accounting for future cleanup and restoration costs, and the practical difficulties they may encounter when they try to implement these criteria.