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Topic Outline:

1. Three Important Characteristics of Liabilities

2. Classifications of Liabilities

• Current Liabilities

• Non-Current Liabilities

1. Criteria for Reclassifying Current Liabilities to Non-Current  Liabilities

• Intent to Refinance

• Ability to Refinance

1. Ways to Account for Warranties

• Assurance Warranty Approach

• Service Warranty Approach

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      I. Introduction

In accounting, liabilities are obligations or debts that a company owes to other parties as a result of past transactions or events. They reflect a company's financial commitments and responsibilities and are crucial parts of its financial structure. Understanding liabilities is essential for evaluating a firm's financial health, liquidity, and capacity to fulfill its debts. The purpose of this introduction is to lay the groundwork for a discussion of the finer points of liabilities, specifically with regard to the characteristics, classification, and reclassification of liabilities as well as warranty obligations, including the standards for classification and accounting procedures.

 

1. Three Important Characteristics of Liabilities

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The three characteristics of liability are the following: 

1. a present obligation

2. a past transaction or event

3. a probable future sacrifice of economic benefits

 

       II. Classifications of Liabilities

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Current Liabilities

Current liabilities are obligations or debts that an organization is expected to pay off within one year or within its normal operating cycle, whichever is longer. Current liabilities, such as accounts payable, short-term loans, accrued expenses, and taxes payable, are usually settled using current assets or by generating new current liabilities. 

 

The normal operating cycle of a company refers to the time it takes a company to turn its resources into cash through production, sales, and collection. This varies depending on the type of business. The time it takes a company to turn its resources into cash through production, sales, and collection is known as the normal operating cycle in accounting. Depending on the type of business, it varies. Debts that are expected to be settled during this cycle are categorized as current, and those that go beyond are categorized as non-current.

 

Non-Current Liabilities

Long-term liabilities, sometimes referred to as non-current liabilities, are obligations or debts that are not expected to be paid off within the company's normal operating cycle or after more than a year, whichever is longer.

 

       III. Criteria for Reclassifying Current Liabilities to Non-Current  Liabilities

An organization must satisfy the following criteria in order to classify an existing current liability as non-current at the balance sheet date:

 

       Intent to Refinance   

In order to refinance current liability into a non-current liability, the organization must have the intent to refinance it. It is necessary to record this intention, usually in the minutes of board or executive committee meetings. 

 

      Ability to Refinance

To be able to refinance a short-term liability into a non-current liability, the company must have the ability to refinance it. This ability can be demonstrated in any of the following ways:

• Before the financial statements are released, but after the balance sheet date, the short-term liability is refinanced into a long-term liability or equity.

• The organization has a financing agreement in place that expressly allows the company to refinance the short-term obligation over an extended period of time. 

 

       IV. Ways to Account for Warranties

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       Assurance Warranty Approach

Expensing the warranty cost at the time of sale allows the organization to account for warranties that are automatically attached to a product's sale and for which no additional revenue is collected. In general, GAAP requires this method.

• The cost of the assurance guarantee is calculated and incurred as a liability in the year that the underlying product is sold.

• The assurance warranty costs expended during the warranty term will be deducted from the assurance warranty liability.

• Future assurance warranty estimates are based on the difference between the original estimate and the actual amount spent; they are adjusted upward or downward as necessary.

 

EXAMPLE: Ardeo Company sells flashlights worth ₱500 with a 3-year warranty. It was estimated by Ardeo Company that the repair cost for each flashlight amounts to ₱15. In year 1, the company sold 500 flashlights and the repair costs incurred were equal to ₱3,000. Compute the warranty expense and warranty liability for year 1.

 

                                                  Warranty Expense for Year 1 = 500 x ₱15 = ₱7,500

                                                  Warranty Liability for Year 1 = ₱7,500 - ₱3,000 = ₱4,500

 

Service Warranty Approach

Extended warranties that are sold separately from the product are accounted for using the GAAP method.

• Over the extended warranty period, revenue from the sale of the extended service warranty is recognized and deferred as a liability.

• Repair costs for goods covered by an extended service warranty are deducted as incurred throughout the duration of the extended service warranty period.

 

EXAMPLE: Ardeo Company sells flashlights worth ₱500 with a 3-year assurance warranty. It was estimated by Ardeo Company that the repair cost for each flashlight amounts to ₱15. The company also offers 2-year extended service warranty for ₱40 if availed at the time of sale. 

 

          a. Compute the revenue and deferred revenue per unit.

              Revenue for each unit at the time of  = ₱500

              Deferred Revenue for each unit = ₱40

 

         b.Compute the revenue that should be recorded from year 1-5 for the extended service revenue.

              Revenue Year 1-3 = 0

              *No revenue will be recorded because the repair costs incurred from year 1-2 will be charged to the assurance warranty attached to the                    product.

 

              Revenue Year 4-5 = ₱40 2 = ₱20

              * Ardeo Company will recognize ₱20 of revenue per year

 

THEORY QUESTIONS

1. Deferred Revenue is recorded in which warranty method?

1. Assurance Warranty Approach

2. Special Warranty Approach

3. Service Warranty Approach

4. Deferred Warranty Approach

 

1. Statement 1: There must be an intent or ability in order to refinance a current liability into non-current liability.

Statement 2: A refinancing agreement does not have to be established before the balance sheet date in order to reclassify a current liability into non-current liability.

1. True, True

2. True, False

3. False, FAlse

4. False, True

 

1. Current Liabilities are obligations that are expected to be paid off

1. After one year

2. Within the operating cycle

3. Within one year or within the normal operating cycle, whichever is shorter

4. Within one year or within the normal operating cycle, whichever is longer

 

1. The important characteristics of a liability are the following except:

1. a probable future sacrifice of financial benefits

2. a probable future sacrifice of economic benefits

3. a present obligation

4. a past transaction or event

 

1. Statement 1: Assurance warranty is not attached to the product at the time of sale.

Statement 2: Repair costs for goods covered by an extended service warranty are added as incurred

1. True, True

2. True, FAlse

3. False, False

4. False, True

 

PROBLEM QUESTIONS

(6-10) Ardeo Inc. is a manufacturer of calculators. The company decided to sell 1,000 calculators in Year 1 and 1,500 calculators in Year 2 for $50 each. The company included a 2-year assurance warranty along with the product. The customers may also purchase a 3-year extended service warranty for $6 if it is purchased at the time of sale. In year 1, Ardeo Inc. incurred repair costs worth $2,000 and $3,500 in year 2.

 

6. How much is the assurance warranty expense in Year 1?

1. 3,500

2. 6,000

3. 50,000

4. 2,000

 

7. How much is the assurance warranty liability for Year 2?

1. 5,500

2. 3,500

3. 4,000

4. 500

 

8. Compute the revenue that should be recorded from year 1-2 for the extended service revenue.

1. 15,000

2. 50,000

3. 125,000

4. 0

 

9. What amount of Sales Revenue will be recognized in Year 1?

1. 0

2. 15,000

3. 50,000

4. 125,000

 

10. How much revenue should be recorded in Year 5 for the extended service warranty?

1. 5

2. 15

3. 2

4. 0

 

ANSWERS

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1. C. Service Warranty Approach

2. D. False, True

3. D. Within one year or within the normal operating cycle, whichever is longer

4. A. a probable future sacrifice of financial benefits

5. C. False, False

6. 1,000 x 6 = 6,000

7. Assurance Warranty Expense - Assurance Warranty Cost = (1,500 x 6) - 3,500 = 5,500 

8. Extended service warranty is offered in the 3rd-5th year. Hence, no revenue should be recorded in  year 1-2 for the extended service revenue. Service Warranty Approach occurs when a company offers an extended warranty for a product, wherein the company must record both deferred revenue and revenue during the warranty contract's duration. 

9. 1,000 x 50 = 50,000

10. 5 3 = 2

 

References

Budd et al. (2022). Wiley CMA Exam Review Study Guide 2022 Part 1: Financial Planning, performance, and Analytics. John Wiley & Sons, Inc.