Acct 230 1st Edition Lecture 22Outline of Last Lecture I. Current Liabilities a. Current LiabilitiesOutline of Current Lecture II. Current Liabilities a. ContingenciesCurrent LectureIII. Contingenciesa. Apply the appropriate accounting treatment for contingenciesi. 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 Liabilities1. Whether we report a loss contingent liability depends on two criteria: a. The likelihood of payment can be:i. Probable—likely to occurii. Reasonably possible—more than remote but less than probable; oriii. Remote—the chance is slightb. The ability to estimate the payment amount is either:i. Known or reasonably estimable; orii. 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 LiabilitiesThese 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 notrequired.v. Accounting Treatment of Contingent Liabilities1. vi. Warranties1. When you buy a new Dell notebook, it comes with a warranty covering the hardware from defect for either a 90-day, one-year, 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 recordwarranty 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 Gains1. 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 statementsb. Assess liquidity using current liability ratiosi. Liquidity Analysis1. 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 Ratios1. It is important to understand the effect of specific transactionson the current ratio and acid-test ratio. 2. Both ratios have the same denominator, current liabilities, so adecrease 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 Management1. 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