Accounting for Long-Term Liabilities

Introduction

Debts, or liabilities, are the claims creditors have against a firm’s assets. Assets consist of anything that the firm owns that is of monetary value, such as real estate, equipment, cash and inventory. You will find a business' debts listed on its balance sheet in the liabilities section immediately following the section listing the firm’s assets. Liabilities are always divided into short-term debt and long-term debt. Short-term debt is referred to as current liabilities and long-term debt as long-term liabilities

This chapter will focus on the liability side of the balance sheet, particularly current and long-term liabilities including capital and operating leases. Pay close attention to the section concerning the classification of leases as capital vs. operating, and how each classification affects other accounts. This concept is tested heavily in the CFA Level 1 exam.

Current Liability Basics

Liabilities

These are obligations a company owes to outside parties. Liabilities represent others' rights to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees.

Current liabilities

            These are debts that are due to be paid within one year or the operating cycle, whichever is longer; further, such obligations will typically involve the use of current assets, the creation of another current liability or the provision of some service.

Long-term liabilities

            These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments.

Uncertainties Regarding Liability Value

            In some cases the timing and/or the total liability may be difficult to estimate:

1. Some companies offer clients a warranty period. The company does not know at the time of the sale who the payee will be. Furthermore, the company does not know when this payment will occur.

2. At year-end some companies will estimate some expenses, and recognize some liabilities such as pension benefits.

Recording and Reporting Estimated and Contingent Liabilities

Liabilities whose timing and amount are known can easily be accounted for. But others - such as warranties, taxes, vacation-pay liability and contingent liabilities, among others - require some estimation.

Warranties

            When a company sells a product, it sometimes offers its customers a warranty of a certain number of years. To be consistent with the matching principle, companies, at the time of the sale, must estimate an amount that must be allocated to the costs associated with the warranties. Most companies will use a historical or industry average to estimate its warranty cost. The estimated warranty cost or liability will be allocated to the estimated warranty liability. For example, say Company ABC sells 100 appliances at $100 and estimates that each appliance will carry a $10 warranty liability.

Contingent Liabilities

            Contingent liabilities are liabilities that will materialize if some future event occurs and are contingent on a specific outcome. The most frequent contingent liability is a pending lawsuit against the company, which will materialize only if the firm is found guilty. Pending lawsuits can be significantly large for some companies, especially those involved in large class action lawsuits with hundreds or even thousands of potential plaintiffs. Examples of these industries include pharmaceuticals, oil companies or any company that produces large amounts of products that can harm consumers.

            The disclosure and/or inclusion of contingent liabilities in a company's financial statements will depend on the company's ability to estimate the amount of the liability and the likelihood that it will occur.

Rules for classifying liabilities:

• If the liability is probable and can be reasonably estimated, it must be included in the company's financial statements. The loss will be included in the financial statements, and the liability must be included on the balance sheet.

• If the liability is probable but cannot be reasonably estimated, then only a footnote disclosure is required.

• If the liability is not probable and cannot be reasonably estimated, then no disclosure is required.

Accounting for Long-Term Liabilities

Mortgages payable

            A mortgage is a long-term debt secured by a real estate property such as a building or land. The mortgage is usually paid back in equal installments. These installments include a portion that is attributable to interest expense and the other to capital repayment.

Long-term leases

Companies generally acquire the right to use an asset by purchasing it outright. But in some cases companies can lease an asset as opposed to an outright purchase. Leases can be classified as operating leases or capital leases. Operating leases are defined as short-term leases by which the company enters into an agreement with the lessor to use the asset for a portion of the asset's economic life. The lessee (the company leasing the equipment) will have no obligation to purchase the asset in the future. Capital leases, on the other hand, are long-term leases that create a long-term obligation for the lessee. If the asset qualifies as a capital lease, the asset is recorded on the balance sheet and the present value of the lease obligations are also recorded on the balance sheet. The asset is amortized over the life of the lease by using a straight-line depreciation method. Each rental payment includes a portion that is allocated to interest expenses and repayment of principal.

 

Pensions
            A pension plan is a qualified retirement plan set up by a corporation, labor union, government or other organization for its employees. A pension plan is an agreement under which the employer agrees to pay monetary benefits to employees once their period of active service has come to an end. A third party frequently manages the pension plan.

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