In addition, American presented the following among its footnote disclosures:

Maturities of long-term debt (including sinking fund requirements) for the next five years are: 2002 - $421 million; 2003 - $212 million; 2004 - $273 million; 2005 - $1.0 billion; 2006 - $777 million.

Required:

Consider the appropriate classification of these long-term debt obligations. All other things being equal, what are the implications of the information above for American's liquidity and solvency risk in 2003 and following?

Answer: Because some of the debt is being reclassified from long-term to current as installment payments come due, the long-term debt will decline. The current portion will decline when large installments come due (all other things equal) on the year-end 2002 and 2003 balance sheets, but sharply increase on the year-end 2004 and 2005 balance sheets. The liquidity of the company will vary inversely to these changes. Also, assuming no new issuance of long-term debt, the balance will be cut nearly in half by the end of 2006, thereby improving the company's solvency (all other things equal).

Learning Objective: 4 Level of Learning: 3

Essay

Instructions:

The following answers point out the key phrases that should appear in students' answers. They are not intended to be examples of complete student responses. It might be helpful to provide detailed instructions to students on how brief or in-depth you want their answers to be.

136. Identify the major components included in the official definition of a liability as set forth by the FASB.

Answer:

The FASB's definition of a liability includes the following:

1. A liability is the result of past transactions or events.

2. A liability involves a probable future transfer of assets or services.

3. A liability represents an obligation to a particular entity.

All three criteria should be met before a liability is recorded.

Learning Objective: 1 Level of Learning: 1

137. Define and distinguish between current and noncurrent liabilities.

Answer: Current liabilities represent claims arising from past transactions or events that are expected to be satisfied with current assets. These current obligations generally must be satisfied within the company's normal operating cycle or one year, whichever is longer. Noncurrent liabilities will not require payment within one year of the balance sheet date nor will they require the use of current assets for payment.

Learning Objective: 4 Level of Learning: 1

138. Define the following:

1. Liabilities that are definite in amount.

2. Liabilities that must be estimated.

3. Liabilities that are contingent.

Answer:

1. Liabilities that are definite in amount - Both the existence and the amount of the liability are determinable due to a contract, trade agreement, or business practice.

2. Liabilities that must be estimated - The existence is determinable but the amount is in question. The amount is estimated and the liability is recorded in the current period.

3. Liabilities that are contingent -No definite liability exists, but there is the potential for obligation based on the outcome of a future event (the contingency). Sometimes the amount is known, but the existence of an obligation is still questionable.

Learning Objective: 1 Level of Learning: 1

139. What factors are important in determining whether a pending lawsuit should be accrued as a liability and reflected in the financial statements?

Answer:

Factors that are important for consideration include:

1. When did the cause of action occur? No liability should be recognized until after the cause of action occurs.

2. Has the case come to trial?

3. Is there an appeal pending?

4. What is the probability of loss according to legal counsel?

5. Has this type of lawsuit occurred before? What was the outcome?

If a loss from a lawsuit is probable and the amount can be reasonably estimated, then a journal entry should be made to recognize the loss. If it is reasonably possible, then only footnote disclosure is required. If the chance of loss is remote, then nothing is required to be disclosed.

Learning Objective: 5 Level of Learning: 1

140. Bank loans are often arranged in advance as lines of credit. What is a line of credit? How do a committed and a noncommitted line of credit differ?

Answer:

Lines of credit permit a company to borrow cash from a bank up to a prearranged amount at a predetermined rate of interest. The interest is frequently floating and tied to some prime rate. Lines of credit usually must be available to support the issuance of commercial paper.

A committed line of credit is formal and usually requires a commitment fee expressed as a percentage of the unused balance. Sometimes a compensating balance is required.

A noncommitted line of credit allows the company to borrow without having to follow a formal loan process at the time the loan is needed. Sometimes a compensating balance is required.

Learning Objective: 2 Level of Learning: 2

141. How are customer advances and refundable deposits similar and yet different?

Answer: When a company collects cash from a customer as a refundable deposit or as an advance payment for products or services, a liability is created obligating the firm to return the deposit or to supply the goods or services. When the amount is to be returned in cash, it is a refundable deposit. When the amount of the deposit is to be applied to the purchase of goods or services, it is a customer advance.

Learning Objective: 3 Level of Learning: 2

142. Define a loss contingency and give two examples that almost always are accrued.

Answer:

A loss contingency is an existing situation, or a set of circumstances, involving potential loss that will be resolved when some future event occurs or doesn't occur.

Two loss contingencies that are almost always accrued include:

1. Manufacturers' warranties - these inevitably involve expenditures and can reasonably be estimated using prior experience.

2. Cash rebates and premium offers - these inevitably involve expenditures and reasonably accurate estimates can be made based on prior experience.

Learning Objective: 5 Level of Learning: 2

143. Texon Oil is being sued for price fixing and environmental damage. The litigation started this year and is expected to last five years. There is no doubt that Texon is guilty but the settlement cost range will be between $3 billion and $22 billion. Briefly explain how Texon would address this in its current year financial statements.

Answer: One has to decide if $3 billion to $22 billion is a reasonably estimable amount. If it is not, disclosure is all that is required. Side issues might include the effect on going concern status and the impact on the auditor's report. Students might suggest accrual of that portion of the cost that becomes reasonably estimable. With a given 5-year litigation period with billions at stake, these costs would be sizable.

Learning Objective: 5 Level of Learning: 3

144. Identify and define the three terms used in FASB statement No. 5 to identify the range of possibilities of accounting action to be taken on contingent liabilities. Describe the accounting action to be taken for each term.

Answer:

1. Probable - The future event is likely to occur. Record the event if the amount is known or reasonably estimable. If it is not estimable, report it in a footnote.

2. Reasonably possible - The chance of the future event occurring is more than remote but less than likely. Report it in a footnote.

3. Remote - Only a slight chance of the future event occurring. No reporting or recording is generally necessary.

Learning Objective: 5 Level of Learning: 1

145. Swift Drug Company is being sued this year for a wrongful death due to violation of FDA rules. There is no doubt that Swift is guilty and the settlement is reasonably estimable at $10 billion payable evenly over 10 years starting next year. Briefly explain how Swift would address this in its current year financial statements.

Answer: In the Swift case, the loss contingency accrual is clearly the full $10 billion. Given the payment terms, the students should note the proper current/noncurrent classification.

Learning Objective: 6 Level of Learning: 2

146. Safeway Inc. is one of the largest food and drug retailers in North America. In its 2005 annual report to shareholders, it made the following disclosure:

In 1987, Safeway assigned a number of leases to Furr's Inc. (Furr's) and Homeland Stores, Inc. (Homeland ) as part of the sale of the Company s former El Paso, Texas and Oklahoma City, Oklahoma divisions. Safeway is contingently liable if Furr's and Homeland are unable to continue making rental payments on these leases. In 2001, Safeway recorded a pretax charge to earnings of $42.7 million to recognize the estimated lease liabilities associated with the Furr's and Homeland bankruptcies and for a single lease from Safeway s former Florida division. In 2002, Furr's began the liquidation process and Homeland emerged from bankruptcy and, based on the resolution of various leases, Safeway reversed $12.1 million of this accrual.

Explain the accounting principle(s) that required Safeway to record the $42.7 million charge in 2001 and the $12.1 million reversal in 2002.

Answer:

SFAS 5 requires that a loss and corresponding liability be recorded when an unresolved matter leading to a loss is probable and reasonably estimable. In this case, the bankruptcy filings by Furr's and by Homeland in 2001 raised the probability of Safeway having to make good on these leases to a point where accrual was necessary. As a result of events in 2002, Safeway made a change in estimate, reducing the contingent loss, and recording a reversal, of $12.1 million.

Learning Objective: 5 Level of Learning: 3

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 45