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Learning Objective 13-02:

VIDEO #1

The most common way for a corporation to obtain temporary financing is to arrange a
short-term bank loan. When a company borrows cash from a bank and signs a promissory
note, the firms liability is reported as notes payable (sometimes bank loans or short-term
borrowings).

Usually short-term bank loans are arranged under an existing line of credit with a bank or
a group of banks. A line of credit is an agreement to provide short-term financing, with
amounts withdrawn by the borrower only when needed. Even though the loans are short-
term, with amounts borrowed and repaid frequently, the agreement to provide a line of
credit typically lasts several years. Lines of credit can be noncommitted or committed.

A noncommitted line of credit is an informal agreement that permits a company to borrow


up to a prearranged limit without having to follow formal loan procedures and paperwork.

A committed line of credit is a more formal agreement that usually requires the company
to pay a commitment fee to the bank to keep a credit line amount available to the
company.

Some large corporations obtain temporary financing by issuing commercial paper, often
purchased by other companies as a short-term investment. Commercial paper refers to
unsecured notes sold in minimum denominations of $25,000 with maturities ranging from
30 to 270 days.

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Learning Objective 13-03:

VIDEO #1

When a company borrows money, it pays the lender interest in return for using the
lenders money during the term of the loan. Accrued interest payable arises as of a
financial statement date when interest is owed but has not yet been paid to the lender. (It
might help if you think of the word accrued as meaning owed.)

Lets assume that Affiliated Technologies, Inc., borrowed $700,000 cash from First
BancCorp on May 1 under a noncommitted short-term line of credit arrangement and
issued a six-month, 12% promissory note. Interest was payable at maturity.

On May 1, Affiliated Technologies will record an entry with a debit to Cash and a credit to
Note payable for $700,000, the amount borrowed. The fiscal period for Affiliated
Technologies ends on June 30.
The company will issue financial statements as of June 30, and the interest that relates to
the two-month period since the note was issued needs to be reflected. On June 30, the
company will record an adjusting entry with a debit to Interest expense and a credit to
Interest payable for $14,000. That amount was calculated by multiplying the amount
borrowed of $700,000 by the annual interest rate of 12% by 2/12, which is the portion of
the year that the amount borrowed has been outstanding.
On November 1, the due date of the note, the company will pay the amount borrowed plus
the full amount of interest due. The company will record an entry with a debit to Interest
expense for $28,000. That amount was calculated by multiplying the amount borrowed of
$700,000 by the annual interest rate of 12% by 4/12, which is the portion of the year that
the amount borrowed has been outstanding. The entry also includes a debit to Interest
payable for $14,000 to remove the amount that had accrued on June 30 from that
account. It also includes a debit to Note payable for $700,000 to remove the amount
borrowed from that account. Finally, the entry includes a credit to Cash for the total
amount paid of $742,000.

VIDEO #2

Compensation for employee services can be in the form of hourly wages, salary,
commissions, and bonuses. Accrued liabilities arise when employees have worked but
have not yet been paid as of a financial statement date. These liabilities and the related
expenses are recorded by adjusting entries at the end of the reporting period, prior to
preparing financial statements.

Lets suppose the firm grants two week of paid vacation each year to nonsalaried
employees. What if a few of the employees have not taken their vacations as of the end of
the year? An employer should accrue an expense and the related liability for employees
compensation for future absences (such as vacation pay) if the obligation meets the
following four conditions.

The liability for paid absences usually is accrued at the existing wage rate rather than at a
rate estimated to be in effect when absences occur. So, if wage rates have risen, the
difference between the accrual and the amount paid increases compensation expense that
year.

Lets illustrate by looking at Davidson-Getty Chemicals, a company with 8,000 employees.


Each employee earns two weeks of paid vacation per year. Vacation time not taken in the
year earned can be carried over to subsequent years. During Year 1, 2,500 employees
took both weeks vacation. At the end of Year 1, 2,500 employees have 2,000 carryover
weeks and 3,500 employees have 7,000 carryover weeks for a total of 9,000 carryover
weeks of vacation. During Year 1, compensation averaged $600 a week per employee.

When the companys employees take their vacations in Year 1, the company will record an
entry that includes a debit to Salaries and wages expense and a credit to Cash (or wages
payable) for $4,200,000. That amount was calculated by multiplying the 2,500 employees
who took their vacations by 2 weeks by the average compensation of $600 per week.
At December 31, Year 1, the company must record an adjusting entry to accrue the
vacation time that is still owed. That entry will include a debit to Salaries and wages
expense and a credit to Liabilitycompensated future absences for $5,400,000. That
amount was calculated by multiplying the 9,000 carryover weeks by the average
compensation of $600 per week.

What about other types of paid absences such as sick pay? Should these be accrued?

If it is customary that a certain type of paid absence can be carried forward or if the rights
in that paid absence vest (that is, it is payable even if employment is terminated), a
liability should be accrued assuming all four of the criteria that we discussed earlier have
been met.

VIDEO #3

In some businesses its typical to require customers to pay cash as a deposit that will be
refunded when a specified event occurs. When cash is collected from a customer as a
refundable deposit, a liability is created.

To illustrate, Rancor Chemical Company sells combustible chemicals in expensive,


reusable containers. Customers are charged a deposit for each container delivered and
receive a refund when the container is returned. Deposits collected on containers
delivered during the year were $300,000. Deposits are forfeited if containers are not
returned within one year. Ninety percent of the containers were returned within the
allotted time. Deposits charged are twice the actual cost of containers. The inventory of
containers remains on the companys books until deposits are forfeited.

When Rancor receives the deposits from its customers, the company will record an entry
that includes a debit to Cash and a credit to Liabilityrefundable deposits for $300,000,
which is the amount of cash received. Since Rancor still owns the containers, they are not
removed from the related inventory account.

When customers return the containers and Rancor refunds the related deposits, the
company will record an entry that includes a debit to Liability refundable deposits and a
credit to Cash for $270,000.

That amount is calculated as $300,000 times 90%, which is the percentage of containers
that were returned.

Once the time for the return of the containers has passed, Rancor will make two adjusting
entries. The first includes a debit to Liabilityrefundable deposits and a credit to Revenue
sale of containers for $30,000. That amount is calculated as $300,000 times 10%, which
is the percentage of container deposits that were forfeited by customers who failed to
return their containers.

In addition, since the containers were not returned, Rancor must record a second entry
that includes a debit to Cost of goods sold and a credit to Inventory of containers for
$15,000.
Deposits charged are twice the actual cost of containers. In other words, the cost of the
containers is 50% of the deposit amount. As such, the cost of the containers not returned
of $15,000 is calculated by multiplying the deposits forfeited of $30,000 times 50%.

VIDEO #4

Some businesses require advance payments from customers that will be applied to the
purchase price when goods are delivered or services are provided. These advances from
customers, also called deferred revenue or unearned revenue, are recorded as liabilities
until the related products or services are provided to customers.

Examples include magazine and newspaper subscriptions, layaway deposits, and airline
and train tickets.
To illustrate, lets consider Tomorrow Publications, a company that collects magazine
subscriptions from customers at the time subscriptions are sold. Subscription revenue is
recognized over the term of the subscription. Tomorrow collected $20 million in
subscription sales during its first year of operations. At December 31, the average
subscription was one-fourth expired.

When customers pay in advance for their magazine subscriptions, Tomorrow Publications
will record an entry that includes a debit to Cash and a credit to Deferred subscription
revenue (or simply Deferred revenue) for $20 million, the amount of cash collected.

Lets assume that each subscriber will receive four quarterly magazines over a one-year
period. Tomorrow Publications had mailed one quarterly magazine to each customer by the
end of its first year of operations. Thus, one-fourth (one magazine out of the four
promised) of the subscription had been fulfilled or expired. (The word expired is often
used when a product or service is provided to the customer over time.) So, as of
December 31, the company recognizes $5 million of subscription revenue, calculated as
the amount received in advance of $20 million times the one-fourth portion of its
performance obligation that it has satisfied.

At December 31, Tomorrow Publications will record an adjusting entry that includes a debit
to Deferred subscriptions revenue and a credit to Subscriptions revenue for $5 million.

VIDEO #5

Gift cards are common forms of advanced payments. When a company sells a gift card, it
initially records the cash received as deferred revenue. The company recognizes revenue
either when the gift card is redeemed or when the probability of redemption is remote,
which is called gift card breakageIf gift cards do not expire, the company will estimate gift
card breakage based on past experience.

To illustrate, lets consider Great Buy, Inc., a company that sells gift cards. During May, the
company sold $2 million of gift cards. Also during May, $1.5 million of gift cards sold in
May and in prior periods were redeemed by customers, and $1 million of gift cards sold in
prior periods expired before they were used.
When Great Buy sells gift cards to customers, the company will record an entry that
includes a debit to Cash and a credit to Deferred gift card revenue for $2,000,000, the
amount of cash collected.

When customers redeem gift cards, the company will record an entry that includes a debit
to Deferred gift card revenue and a credit to Revenuegift cards for $1,500,000, the
amount of gift cards that were used. (We are ignoring the entry required for inventory and
cost of sales.)

At May 31, the company will record an adjusting entry that includes a debit to Deferred
subscriptions revenue and a credit to Revenuegift cards for $1,000,000, which is the
amount of gift cards that expired unused.

VIDEO #6

Companies often make collections for third parties from customers or from employees and
periodically remit (that is, pay) these amounts to the appropriate governmental (or other)
units. Examples include sales taxes collected from customers and union dues or charitable
contributions withheld from employee paychecks. Amounts collected this way represent
liabilities until remitted.

To illustrate, lets consider a customer who pays cash to purchase $100 of merchandise
from a store located in an area with a state sales tax of 4% and a local sales tax of 3%.
The store will collect sales tax of $7, calculated as $100 times the sum of 4% and 3%.

To record the sale, the store will record an entry that includes a debit to Cash for $107 (or
$100 plus the applicable sales taxes of $7), a credit to Sales revenue for $100 (the amount
of the sale), and a credit to Sales taxes payable of $7. (We are ignoring the entry required
for inventory and cost of sales.)

The company will be required to prepare a sales tax return and remit the sales tax. When
it is remitted, the company will debit Sales taxes payable and credit Cash.

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Learning Objective 13-05:

VIDEO #1

A loss contingency is an existing, uncertain situation involving potential loss depending on


whether some future event occurs. For example, a customer who was injured using a
product purchased from a company might sue the company. A loss contingency would
then arise.

Whether a loss contingency is accrued and reported as a liability depends on (a) the
likelihood that the confirming event will occur and (b) what can be determined about the
amount of loss.
Generally accepted accounting principles require that the likelihood that the future
event(s) will confirm the incurrence of the liability be (somewhat arbitrarily) categorized as
probable, reasonably possible, or remote. Probable means the confirming event is likely to
occur.Reasonably possible means the chance the confirming event will occur is more than
remote but less than likely.Remote means the chance the confirming event will occur is
slight.

Lets summarize the appropriate accounting treatment of each possibility. If a loss is


probable and the amount is known, the liability should be accrued and disclosed in a note.
The same is true if a loss is probable and the amount can be reasonably estimated. On the
other hand, if the loss is probably but the amount cannot be reasonably estimated, a
liability is not recorded. Instead, the loss contingency is disclosed. If a loss is only
reasonably possible, a liability is not recorded. Instead, the loss contingency is disclosed.
And, if a loss is remote, a liability is not recorded and disclosure is not necessary.

What if the range of loss is known, but no amount within that range is more likely that the
others? In this case, the minimum amount should be recorded and the possible additional
loss should be disclosed.
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Learning Objective 13-06:

VIDEO #1

Sellers offer quality-assurance warranties to boost sale. This type of warranty is a


guarantee by the seller that the customer will be satisfied with the goods or services that
the seller provided.

The costs of making good on such guarantees should be estimated and recorded as
expenses in the same accounting period the products are sold. The estimated liability may
be classified as current or as part current and part long-term, depending on when warranty
claims are expected to be satisfied.

Lets consider Caldor Health, a supplier of in-home health care products, which introduced
a new therapeutic chair carrying a two-year warranty against defects. Estimates based on
industry experience indicate warranty costs of 3% of sales during the first 12 months
following the sale and 4% the next 12 months. During December, its first month of
availability, Caldor sold $2 million of chairs.

To record the sales, Caldor Health will record an entry that includes a debit to Cash (or
Accounts receivable) and a credit to Sales revenue for $2,000,000. (We are ignoring the
entry required for inventory and cost of sales.)

At December 31, 2018, Caldor Health will accrue this loss contingency in an adjusting
entry. The company will estimate its warranty costs relating to these sales by summing the
expected warranty cost percentages of 3% of sales during the first 12 months following
the sale and 4% of sales during the next 12 months and then multiply this sum by the
sales of $2,000,000.

The adjusting entry will include a debit to Warranty expense and a credit to Estimated
warranty liability for the estimated warranty costs of $140,000.

Lets assume the actual warranty costs incurred during Year 2 totaled $61,000. When
customer claims are made and costs are incurred to satisfy those claims, the liability is
reduced. Candor Health will record an entry

VIDEO #2

Recall that a loss contingency is an existing, uncertain situation involving potential loss
depending on whether some future event occurs.

If a loss is probable and the amount is known, the liability should be accrued and disclosed
in a note. The same is true if a loss is probable and the amount can be reasonably
estimated. On the other hand, if the loss is probable but the amount cannot be reasonably
estimated, a liability is not recorded. Instead, the loss contingency is disclosed. If a loss is
only reasonably possible, a liability is not recorded. Instead, the loss contingency is
disclosed And, if a loss is remote, a liability is not recorded and disclosure is not necessary.
Companies are faced with various legal actions. For example, a customer might sue
because of an injury caused by an alleged product defect. A competitor might sue claiming
trademark or patent infringement. The claims arising from pending litigation are loss
contingencies and should be accounted for in this manner.

However, in practice, companies often do not record a loss until the litigation has been
settled. And, while they should, companies may not include the extensive disclosure that
is required in the notes to the financial statements. Managers may justify these decisions
by claiming that recording an accrual and providing the required disclosure will provide
damaging information to the opposing counsel.

Even after a firm loses in court, it may not make an accrual. For example, consider this
note from a companys financial statements, which reads as follows. The Company
believes that it has valid bases in law and fact to appeal these verdicts. As a result, the
Company believes that the likelihood that the amount of the judgments will be affirmed is
not probable, and, accordingly, that the amount of any loss cannot be reasonably
estimated at this time. Because the Company believes that this potential loss is not
probable or estimable, it has not recorded any reserves or contingencies related to this
legal matter.

VIDEO #3

Several weeks usually pass between the end of a companys fiscal year and the date the
financial statements for that year are distributed. During that time, a significant
development might take place after the companys fiscal year-end but before the financial
statements are issued. Such a development is called a subsequent event.

To illustrate, lets assume Carrington Company has a calendar year-end and distributes its
financial statements to users on February 28. Lets assume that a lawsuit was filed against
Carrington during the year. The cause of the lawsuit took place before year-end, so it is a
loss contingency. However, based on the information available at year-end, the possibility
of a loss was remote. Thus, the company did not plan to record an accrual for or disclose
the loss contingency in its financial statements.

Information becomes available during February that shed light on the litigation that
existed at year-end. Based on that information, the possibility of the loss is now
determined to be reasonably possible. Because of this subsequent event, the company
should disclose the loss contingency in its financial statements when it distributes them on
February 28.

What if additional information became available after the financial statements had been
issued? For example, lets assume that the company decided to settle the lawsuit in March
because it was generating negative publicity. Now the loss is probable because a
settlement was paid. Since this information was not available at the time the financial
statements were distributed, those financial statements would not be changed. Instead, in
this example, the loss would be recorded during March and be reflected in that years
financial statements.

Now, lets consider what happens if an event giving rise to a loss contingency happens
after year-end. For example, assume that the companys warehouse was destroyed by fire
during February. This event does not meet the loss contingency criteria since it arose after
year-end. However, any event occurring after the fiscal year-end but before the financial
statements are issued that has a material effect on the companys financial position must
be disclosed in a subsequent events disclosure note.

VIDEO #4

Lets suppose a trucking company frequently transports hazardous waste materials and is
subject to environmental laws and regulations. Management has identified several sites at
which it is or may be liable for remediation. Even if a claim has not been made by the time
the financial statements are issued, unasserted claims and assessments may still warrant
accrual or disclosure.
When unasserted claims exist as of year-end, the following process should be applied First,
ask if it is probable that a claim will be asserted. If the answer to that question is no,
stop. No accrual or disclosure is necessary. If the answer is yes, treat the claim as if the
claim has been asserted. That requires evaluating the likelihood of an unfavorable
outcome and whether the dollar amount of loss can be estimated to determine if a loss
contingency must be accrued and/or disclosed.

VIDEO #5

A gain contingency is an uncertain situation that might result in a gain.

For example, in a pending lawsuit, the defendant faces a loss contingency while the
plaintiff has a gain contingency.

Gain contingencies are not accrued. This is an example of conservatism following the
reasoning that its desirable to anticipate losses, but recognizing gains should await their
realization. Though gain contingencies are not recorded in the accounts, material ones are
disclosed in notes to the financial statements.