J-1

Appendix
Other Significant
J Liabilities
Accounting in Action
Learning Objectives
After studying this chapter, you should be able to:

[1] Describe the accounting and disclosure requirements for contingent

liabilities.

[2] Contrast the accounting for operating and capital leases.

[3] Identify additional fringe benefits associated with employee compensation.

J-2
 Contingent Liabilities

Potential liability that may become an actual liability in the

future.

Three levels of probability:

 Probable.
 Reasonably possible.
 Remote.

J-3 LO 1
 Contingent Liabilities

Probability Accounting

Probable Accrue

Reasonably
Footnote
Possible

Remote Ignore

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 Contingent Liabilities

Question
A contingent liability should be recorded in the accounts when:
a. it is probable the contingency will happen, but the
amount cannot be reasonably estimated.
b. it is reasonably possible the contingency will happen, and
the amount can be reasonably estimated.
c. it is probable the contingency will happen, and the
amount can be reasonably estimated.
d. it is reasonably possible the contingency will happen, but
the amount cannot be reasonably estimated.

J-5 LO 1
 Contingent Liabilities

Recording a Contingent Liability

Product warranty contracts result in future costs that
companies may incur in replacing defective units or
repairing malfunctioning units.
Estimated cost of honoring product warranty contracts
should be recognized as an expense in the period in
which the sale occurs.

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 Contingent Liabilities

Illustration: Denson Manufacturing Company sells 10,000

washers and dryers at an average price of $600 each. The
selling price includes a one-year warranty on parts. Denson
expects that 500 units (5%) will be defective and that warranty
repair costs will average $80 per unit. In 2015, the company
honors warranty contracts on 300 units, at a total cost of
$24,000. At December 31, compute the estimated warranty
liability.

Illustration J-1
Computation of estimated
product warranty liability

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 Contingent Liabilities

Illustration: Denson Manufacturing Company sells 10,000

washers and dryers at an average price of $600 each. The
selling price includes a one-year warranty on parts. Denson
expects that 500 units (5%) will be defective and that warranty
repair costs will average $80 per unit. In 2015, the company
honors warranty contracts on 300 units, at a total cost of
$24,000. At December 31, compute the estimated warranty
liability. Make the required adjusting entry.

Warranty Expense 40,000

Warranty Liability 40,000

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 Contingent Liabilities

Illustration: Prepare the entry to record the repair costs

incurred in 2015 to honor warranty contracts on 2015 sales.

Warranty Liability 24,000

Repair Parts 24,000

Assume that the company replaces 20 defective units in

January 2016, at an average cost of $80 in parts and labor.

Warranty Liability 1,600

Repair Parts 1,600

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 Contingent Liabilities

Disclosure of Contingent Liabilities

Illustration J-2

J-10 LO 1
 Appendix
Other Significant
J Liabilities
Accounting in Action
Learning Objectives
After studying this chapter, you should be able to:

[1] Describe the accounting and disclosure requirements for contingent

liabilities.

[2] Contrast the accounting for operating and capital leases.

[3] Identify additional fringe benefits associated with employee compensation.

J-11
 Lease Liabilities

A lease is a contractual arrangement between a lessor (owner

of the property) and a lessee (renter of the property).

Illustration J-3
Types of leases

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 Lease Liabilities

Operating Lease Substance

Rent Expense xxx versus
Cash xxx Form

Although technically legal

Capital Lease
title may not pass, the
Leased Equipment xxx
benefits from the use of
Lease Liability xxx
the property do.

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 Lease Liabilities

For a capital lease, the FASB has identified four criteria.

1. Lease transfers ownership of the property to the lessee.

2. Lease contains a bargain-purchase option.

3. Lease term is equal to 75 percent or more of the estimated

economic life of the leased property.
One or more
4. The present value of the minimum lease
must be met
payments (excluding executory costs) for capital
equals or exceeds 90 percent of the fair lease
value of the leased property. accounting.

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 Lease Liabilities

Illustration: Gonzalez Company decides to lease new

equipment. The lease period is four years; the economic life of
the leased equipment is estimated to be five years. The present
value of the lease payments is $190,000, which is equal to the
fair market value of the equipment. There is no transfer of
ownership during the lease term, nor is there any bargain
purchase option.

Instructions
(a) What type of lease is this? Explain.
(b) Prepare the journal entry to record the lease.

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 Lease Liabilities
Illustration: (a) What type of lease is this? Explain.

Capitalization Criteria: Capital Lease?

1. Transfer of ownership NO
2. Bargain purchase option NO
3. Lease term => 75% of Lease term
economic life of leased
property 4 yrs.
Economic life
4. Present value of minimum
lease payments => 90% of 5 YES
yrs. - PV and FMV
FMV of property YESare the same.

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 Lease Liabilities
Illustration: (b) Prepare the journal entry to record the lease.

Leased Asset - Equipment 190,000

Lease Liability
190,000

The portion of the lease liability expected to be paid in the next year is a
current liability. The remainder is classified as a long-term liability.

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 Lease Liabilities

Question
The lessee must record a lease as an asset if the lease:

a. transfers ownership of the property to the lessor.

b. contains any purchase option.

c. term is 75% or more of the useful life of the leased

property.

d. payments equal or exceed 90% of the fair market

value of the leased property.

J-18 LO 2
 Appendix
Other Significant
J Liabilities
Accounting in Action
Learning Objectives
After studying this chapter, you should be able to:

[1] Describe the accounting and disclosure requirements for contingent

liabilities.

[2] Contrast the accounting for operating and capital leases.

[3] Identify additional fringe benefits associated with employee

compensation.

J-19
 Additional Liabilities for Employee
Fringe Benefits

Paid Absences
Paid absences for vacation, illness, and holidays.

Accrue a liability if:

 Payment of the compensation is probable.
 The amount can be reasonably estimated.

J-20 LO 3
 Employee Fringe Benefits

Illustration: Academy Company employees are entitled to one

day’s vacation for each month worked. If 30 employees earn an
average of $110 per day in a given month.

Vacation Benefits Expense 3,300

Vacation Benefits Liability 3,300

Academy pays vacation benefits for 10 employees.

Vacation Benefits Liability 1,100

Cash 1,100

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 Employee Fringe Benefits

Postretirement Benefits
Post-retirement benefits are benefits that employers
provide to retired employees for

1. health care and life insurance

2. pensions.

Companies account for post-retirement benefits on the

accrual basis.

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 Employee Fringe Benefits

Postretirement Health-Care and Life Insurance

Benefits
 Companies estimate and expense postretirement costs
during the working years of the employee.
 Companies rarely sets up funds to meet the cost of the
future benefits.
► Pay-as-you-go basis for these costs.
► Major reason is that the company does not receive a
tax deduction until it actually pays the medical bill.

J-23 LO 3
 Employee Fringe Benefits Pension
Plans
An arrangement whereby an employer provides benefits to employees
after they retire for services they provided while they were working.

Pension
PensionPlan
Plan
Administrator
Administrator

Employer
Employer Contributions

Retired
Employees Benefit Payments Assets &
Liabilities

J-24 LO 3
 Employee Fringe Benefits Pension
Plans

Defined-Contribution Plan Defined-Benefit Plan

 Employer contribution  Benefit determined by plan
determined by plan (fixed)  Employer contribution varies
 Risk borne by employees (determined by Actuaries)
 Benefits based on plan value  Risk borne by employer

 Companies record pension costs as an expense.

 Actuaries estimate the employer contribution by considering
mortality rates, employee turnover, interest and earning rates, early
retirement frequency, future salaries, etc.

J-25 LO 3
 Copyright

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