Operating Liabilities and Time Value of Money

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FADM Term 1 2018

Session #6:

Operating Liabilities and Time Value of Money

Learning Objectives

• Understand common types of operating liabilities
• Account for provisions and contingencies
• Implement time-value-of-money concepts

Liabilities

A liability is:

• A present obligation (legal or constructive)

• Legal obligations are created by contracts. EG: bank loans, arrangements with vendors, rental agreements.
• Constructive obligation arises if past practice creates a valid expectation on the part of a third party. EG: sales returns, product warranties.

• Created by a past event (the “obligating event”)
• Will require an outflow of resources (cash, inventory, labor, etc)
• Payment is unavoidable
• The amount can be estimated reliably

OPERATING Liabilities

Operating liabilities

• Arise from the company’s operating cycle
• Are not related to financing or financing-associated costs and obligations
• Are typically interest-free

Current operating liabilities are due within one year

• Accounts payable
• Accrued expenses (provisions) eg: wages payable, taxes payable, etc.
• Unearned revenues
• Customer deposits
• Current deferred income tax liabilities

Long-term operating liabilities are due beyond one year

• Warranty provision
• Pension liabilities
• Long-term deferred income tax liabilities

Deferred Revenue

Obligation created by “past event” involving a customer
BUT where revenue has not yet been earned.

Examples of Deferred (Unearned) Revenue

• Cash deposits from customers
• Advance billings on contracts
• Subscriptions

Example: On 1 January, 2018 Wall Street Journal receives $18,000 cash from customers for journal deliveries during calendar year 2018. How should WSJ record the cash received? What monthly adjustment should be made during 2018?

Provisions: Liabilities of Uncertain Timing or Amount

Must recognize a PROVISION on the BS and IS if, and only if:

• A present obligation exists
• The obligating event creates an unavoidable legal or constructive obligation
• Payment is more likely than not (probability of future payment >50%)
• The amount can be estimated reliably

Measuring provisions  

• Recognize the “best estimate” of the amount required to settle the obligation
• Use discounted present value if doing so is material
• Best estimate depends on the nature of the obligating event:

• One-off events (restructuring, environmental clean-up, lawsuits) are measured at the most likely amount
• Large population events (warranties, customer refunds) are measured at a probability-weighted expected value.

Contingent Liabilities and Assets

Contingent liabilities

• Payment is possible (probability of future payment < 50%)
• Existence will be confirmed by future events that are not wholly within the control of the entity. Example: defendant in litigation where settlement is not probable.
• NOT RECOGNIZED as a provision on the balance sheet
• Disclosed in the notes (unless the possibility of payment is remote).

Contingent assets

• “Possible” assets (probability future benefit < 50%)
• Existence will be confirmed by future events that are not wholly within the control of the entity. Example: plaintiff in litigation where settlement is not probable.
• Not recognized as an asset on the balance sheet
• Disclosed in the notes when it is more likely than not (>50%) that an inflow of benefits will occur.

Provisions and Contingencies

A retail store has a long-standing policy of allowing customers to return goods within 30-days. Historical data show that about 5% of sales are returned.  Sales for March were $87 million and the company has a gross margin of 42%.

 This assumes that the returned product can be resold. If not, the COGS / Inventory adjustment would not happen. 

A pharmaceutical firm faces a class-action lawsuit that involves over 100,000 plaintiffs. Company lawyers believe that the court will likely dismiss the suit but that a settlement would be approximately $10,000 per plaintiff.

NO entry because the future cash outflow is not likely. Firm will disclose only.

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