CHAPTER 13 CURRENT LIABILITIES AND CONTINGENCIES Overview This chapter focuses on short term liabilities Bonds and long term notes are discussed in the next chapter Obligations relating to income taxes pensions and leases are the subjects of chapters 19 20 and 21 respectively In Section 1 of this chapter we discuss open accounts and notes accrued liabilities and other liabilities that are classified appropriately as current In Section 2 we turn our attention to situations in which there is uncertainty as to whether an obligation really exists These are designated as loss contingencies Learning Objectives 1 Define liabilities and distinguish between current and long term liabilities 2 Account for the issuance and payment of various forms of notes and record the interest on the notes 3 Characterize accrued liabilities and liabilities from advance collection and describe when and how they should be recorded 4 Determine when a liability can be classified as a noncurrent obligation 5 Identify situations that constitute contingencies and the circumstances under which they should be accrued 6 Demonstrate the appropriate accounting treatment for contingencies including unasserted claims and assessments 7 Discuss the primary differences between U S GAAP and IFRS with respect to current liabilities and contingencies CHARACTERISTICS OF LIABILITIES Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable agreements Some liabilities are not contractual obligations and may not be payable in cash A liability has three essential characteristics Liabilities 1 are probable future sacrifices of economic benefits 2 that arise from present obligations to transfer goods or provide services to other entities 13 1 3 that result from past transactions or events Notice that the definition of a liability involves the present the future and the past It is a present responsibility to sacrifice assets in the future caused by a transaction or other event that already has happened WHAT IS A CURRENT LIABILITY Classifying liabilities as either current or long term helps investors and creditors assess the relative risk of a company s liabilities Generally current liabilities are payable within one year Formally current liabilities are expected to require current assets or create current liabilities Conceptually liabilities should be recorded at their present values but ordinarily are reported at their maturity amounts 13 2 13 3 CURRENT LIABILITIES 13 4 General Mills Inc Balance Sheet in millions May 31 2009 and May 25 2008 Assets by classification Liabilities CURRENT LIABILITIES 2009 Accounts payable 803 Current portion of long term debt 509 Notes payable 812 Deferred income taxes Other current liabilities 1 482 Total current liabilities 3 606 LONG TERM LIABILITIES listed individually 2008 937 442 2 209 28 1 240 4 856 Shareholders equity by source 8 Debt Notes Payable The components of notes payable and their respective weighted average interest rates at the end of the period are as follows 2009 Dollars in millions Note 1 2008 Weighted Average Interest Payable Note Rate Weighted Average Interest Payable Rate U S commercial paper Euro commercial paper Financial institutions Total notes payable 402 275 135 812 13 5 0 5 688 0 5 1 386 12 9 135 2 6 2 209 2 9 3 4 9 6 3 6 To ensure availability of funds we maintain bank credit lines sufficient to cover our outstanding short term borrowings Commercial paper is a continuing source of short term financing We issue commercial paper in the United States Canada and Europe Our commercial paper borrowings are supported by 2 9 billion of fee paid committed credit lines consisting of a 1 8 billion facility expiring in October 2012 and a 1 1 billion facility expiring in October 2010 We also have 401 9 million in uncommitted credit lines which support our foreign operations As of May 31 2009 there were no amounts outstanding on the feepaid committed credit lines and 134 7 million was drawn on the uncommitted lines 13 6 NOTE ISSUED FOR CASH Interest on notes is calculated as FACE AMOUNT x ANNUAL RATE x TIME TO MATURITY On May 1 Affiliated Technologies Inc a consumer electronics firm borrowed 700 000 cash from First BancCorp under a noncommitted short term line of credit arrangement and issued a 6 month 12 promissory note Interest was payable at maturity May 1 Cash Notes payable November 1 Interest expense 700 000 x 12 x 6 12 Notes payable Cash 700 000 42 000 13 7 700 000 42 000 700 000 700 000 742 000 Noninterest Bearing Note The proceeds of the note are reduced by the interest in a noninterest bearing note Situation 700 000 noninterest bearing note with a 12 discount rate The 42 000 interest is discounted at the outset rather than explicitly stated May 1 Cash difference Discount on notes 700 000 x 12 x 6 12 Notes payable face amount 658 000 42 000 November 1 Interest expense Discount on notes 42 000 Notes payable face amount Cash 700 000 700 000 42 000 700 000 The amount borrowed is only 658 000 but the interest is calculated as the discount rate times the 700 000 face amount This causes the effective interest rate to be higher than the 12 stated rate 42 000 658 000 6 38 12 6 x interest for 6 months amount borrowed rate for 6 months to annualize the rate 12 76 effective interest rate 13 8 ACCRUED LIABILITIES Liabilities accrue for expenses that are incurred but not yet paid Recorded by adjusting entries at the end of the reporting period prior to preparing financial statements Common examples are salaries and wages payable income taxes payable and interest payable 13 9 ACCRUED INTEREST PAYABLE Assume the fiscal period for Affiliated Technologies ends on June 30 two months after the 6 month note is issued The issuance of the note intervening adjusting entry and note payment would be recorded as shown below Issuance of note May 1 Cash Note payable 700 000 Accrual of interest on June 30 Interest expense 700 000 x 12 x 2 12 Interest payable 14 000 Note payment November 1 Interest expense 700 000 x 12 x 4 12 Interest payable from adjusting entry Note payable Cash 700 000 42 000 28 000 14 000 700 000 13 10 700 000 14 000 742 000 Customer Advance A customer advance produces an obligation that is satisfied when the product or service is provided Tomorrow Publications collects magazine subscriptions from customers at the time subscriptions are sold Subscription revenue is recognized over the term of the subscription Tomorrow collected 20