Acct 230 1st Edition Lecture 22 Outline of Last Lecture I Current Liabilities a Current Liabilities Outline of Current Lecture II Current Liabilities a Contingencies Current Lecture III Contingencies a Apply the appropriate accounting treatment for contingencies i Contingent liability 1 An existing uncertain situation that might result in a loss 2 Examples Lawsuits product warranties environmental problems and premium offers ii A contingent liability may not be a liability at all Whether it is depends on whether an uncertain event that might result in a loss occurs or not iii Contingent Liabilities 1 Whether we report a loss contingent liability depends on two criteria a The likelihood of payment can be i Probable likely to occur ii Reasonably possible more than remote but less than probable or iii Remote the chance is slight b The ability to estimate the payment amount is either i Known or reasonably estimable or ii Not reasonably estimable 2 We record a liability if the loss is probable and the amount is at least reasonably estimable 3 The journal entry to record a contingent liability requires a debit to a loss or expense account and a credit to a liability iv Contingent Liabilities These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute 1 If the likelihood of payment is probable and if one amount within a range appears more likely we record that amount 2 When no amount within the range appears more likely than others we record the minimum amount and disclose the potential additional loss 3 If the likelihood of loss is reasonably possible rather than probable we record no entry but make full disclosure in a footnote to the financial statements to describe the contingency 4 If the likelihood of payment is remote disclosure usually is not required v Accounting Treatment of Contingent Liabilities 1 vi Warranties 1 When you buy a new Dell notebook it comes with a warranty covering the hardware from defect for either a 90 day oneyear or two year period depending on the product a Why does Dell offer a warranty i To increase sales of course 2 Based on the matching principle the company needs to record warranty expense in the same accounting period as the sale 3 A warranty represents an expense and a liability at the time of the sale because it meets the criteria for recording a contingent liability 4 Even though Dell doesn t know exactly at the time of the sale what that warranty expense will be it can based on experience reasonably estimate the amount vii Contingent Gains 1 Is an existing uncertain situation that might result in a gain which often is the flip side of contingent liabilities 2 In a pending lawsuit one side the defendant faces a contingent liability while the other side the plaintiff has a contingent gain 3 We record contingent liabilities when the loss is probable and the amount is reasonably estimable 4 We do not record contingent gains until the gain is certain 5 Though firms do not record contingent gains in the accounts they sometimes disclose them in notes to the financial statements b Assess liquidity using current liability ratios i Liquidity Analysis 1 Liquidity refers to having sufficient cash to pay currently maturing debts ii Working Capital 1 It is the difference between current assets and current liabilities iii Current ratio 1 We calculate it by dividing current assets by current liabilities iv Acid test ratio Quick ratio 1 We calculate it by dividing quick assets by current liabilities 2 Quick assets include cash short term investments and accounts receivable v Effect of Transactions on Liquidity Ratios 1 It is important to understand the effect of specific transactions on the current ratio and acid test ratio 2 Both ratios have the same denominator current liabilities so a decrease in current liabilities will increase the ratios and an increase in current liabilities will decrease the ratios 3 Both ratios include cash current investments and accounts receivable so an increase in any of those will increase both ratios 4 Only the current ratio includes inventory and other current assets so an increase in these accounts will increase the current ratio but not the acid test ratio vi Liquidity Management 1 Can management influence the ratios that measure liquidity a Yes at least to some extent 2 A company can influence the timing of accounts payable recognition by asking suppliers to change their delivery schedules 3 The timing of accounts payable recognition could mean the difference between an unacceptable ratio and an acceptable one or between violating and complying with a debt covenant 4 A debt covenant is an agreement between a borrower and a lender that requires certain minimum financial measures be met or the lender can recall the debt