 Hello and welcome to this session. This is Professor Farhad and this session we would look at contingent liabilities and times interest ratio. This topic is covered introductory accounting course as well as the CPA exam. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, finance and tax lectures. This is a list of all the courses that I cover. If you like my recording, please like them, share them, put them in playlist, subscribe. If they benefit you, it might means they might benefit other people and connect with me on Instagram. On my website farhadlectures.com you will find additional resources to supplement your accounting education and pass your CPA exam. If you're looking for those extra seven to 10 points, my website can help you pass and put that exam behind you. So when we talk about contingent liability, what do we need to think about? Think about a lawsuit. The company is being sued. Think about you have an environmental cleanup. You have the obligation to clean up. You don't know how much it's gonna cost you. You don't know you're being sued. You don't know if you're gonna win, if you don't know you're gonna lose and if you lose, you don't know how much you are going to lose. So from an accounting perspective, what do we have to do as a company? Well, as a company, we have to estimate our probability of future loss. So what is the probability of losing? And we're gonna look under three categories and think of remote as no chance. So let's assume we got sued and we don't think there's no chance. No chance means zero to 5%. Now those zero to 5%, they are not in the literature. I'm just telling you, zero to 5% is a very low probability. There's no chance of losing. Company gets sued all the time. If there's no chance you are going to lose, you don't even have to disclose. You don't even have to say anything about the case. Just like a tree fell in the forest, no one knows about it, nothing really happened. Okay? If the probability is possible, now if we went from remote to possible, let's say possible around 50% chance. There's a 50% chance you might lose. We're not really sure. We could lose, we may not lose. We don't know. If it's possible, what do you have to do if the contingent liability is possible? What you have to do is you have to disclose in the notes. So in the notes of the financial statements, you would write a paragraph stating, I am being sued by such and such party in such and such court, and these are the merits for the case. You just have to disclose. Disclose. Now what happened if the probability is probable? Probable think about there's a 90% chance. Again, these percentages, I'm just making them up to kind of put quantity on the quality factors. So just trying to put a number, there's really no number. But 90%, it's a high probability you are going to lose. If there's a 90% chance you are going to lose, then you have to determine, can you estimate the loss? You know you are going to lose, but you could lose $10, you could lose $10,000, you could lose $10 million. You don't know because you cannot estimate. You're waiting for the judge or the jury. If that's the case, you also disclose. If the probability of losing is probable and so notice probable and estimatable, and you can estimate the amount of the loss. If that's the case, if you know you are going to lose, there's a good chance you are going to lose. The evidence is stacked against you and you are, you know you are going to lose. The science is proven that you are at fault. Then you have to record a liability. You debit an expense, then you credit a liability. So notice, you only record a liability if two conditions exist. It is probable one and estimatable two. You have to know the amount of the loss. So that's very important to remember. So what are some potential examples of liabilities? Legal claims, you are being sued. A potential claim is recorded if the amount can be reasonably estimated and it's probable as I just told you. What happened if you have a debt guarantees? What is a debt guarantees? Debt guarantees is when you guarantee the debt of others. Simply put, someone goes to the bank and they will need to borrow money. Well, the bank says, well, am I going to lend you money because I don't know who you are? They would say, okay, I will bring my friend or my parents or someone else that will guarantee my loan. Well, companies do the same thing, but one company will guarantee the debt of another company. If that happened, if you guarantee the debt of another company, you have to disclose. You have to disclose. If the party that you guaranteed the debt to cannot pay if it's probable, they will default. They will not pay. Then you have to record a liability. So for that guarantees, the minimum you have to do is you have to disclose. There's, you know, you have to disclose that you are guaranteeing the debt of others. Now, one thing that Enron, if you heard of the company, Enron, Enron guaranteed the debt of their subsidiaries, but they never even disclosed it. So they were hiding the debt. Other contingencies might include environmental damages, possible tax assessment. You might have a decision by the IRS against you, spending, insurance losses. And if the government is investigating you and as a result you might lose, that's also a potential contingency. Now, let's not talk, let's talk about uncertainties. Uncertainties are different. Uncertainties from future event are not contingent liabilities because contingent liabilities is you are waiting for an outcome. Here you are not waiting for an outcome. In certainties you are predicting the futures. You cannot book a liability for uncertainties. Simply put, you cannot say, well, in the future I might get sued and I might lose or in the future I might have an environmental cleanup obligation. Therefore I will, I can book an expense. You can do that. Uncertainties are different than contingent liabilities. They're not even disclosed. You don't disclose them. Now, some companies they outline the risk, outline the risk for their business, but that's not a contingent liability. That's not a contingent liability. So let's take a look at an example just to kind of see how contingent liabilities work. For the separate situation indicate whether crews should record a liability, disclose or have no disclosure. Crews guarantee the $100,000 debt of a supplier. It's not probable that the supplier will default. Well, once we have a guarantee of a debt, the minimum is you have to disclose. The good news is they're not going to, they're not going to default. Therefore all we have to do is disclose in the notes. Now, if the problem read, it is probable. It is probable that the supplier will default. We go from, we still have to disclose, obviously, but now we have to record a liability as well. Because when you disclose, when you record a liability, you usually have a disclosure too. But the point that all you have to do is disclose under those scenarios. A disgruntled employee is suing crews. Legal advisor believe that the company will likely need to pay the damages, okay? But the amount cannot be reasonably estimated. Well, we are going to have to pay, but we don't know how much. Well, it's probable we are going to lose. It means the company is at fault. We disclose. If it says the amount is $50,000, then we still disclose, obviously, but also we have to record a liability. At this point, it is probable we are going to lose and we know the amount, therefore we record a liability. The next topic we're gonna be looking at here is times interest earned. And what is times interest earned? Every time you hear the word interest, every time you hear the word debt, it means we are talking evaluating the risk of the company. How risky are we? Because interest comes with debt and debt is risk. So let's take a look at the formula first. Times interest earned is computed by taking income before interest and taxes. In the real world, the numerator is called EBIT, earning before interest and taxes rather than income. Here you would say it's I-BIT, okay? It's in the real world, it's EBIT earnings before interest and taxes. So if you look at some companies financial statements, they use the EBIT. They said EBIT is an important number. It's your earning before your interest obligation and your taxes. Then you will divide that amount by your interest expense. So simply put, let's use some simple numbers. If you have $100 in income before interest and taxes and you have interest expense of 10, the ratio is 10. How do you interpret this ratio? This ratio of 10 says that from your earnings, from your earnings, you can cover your interest expense 10 times. Now, the higher this earned, the higher this coverage, the better off you are. So if you have a higher coverage, okay? If you have a higher coverage, that's good. So 15 is better than 10, 20 is better than 10 here. But let's assume your interest is $50. Now, the answer is two. Two is not good. That means from your earning, you can only cover your interest expense twice. Now, why is this ratio important? This is an extremely important ratio because income before interest and taxes varies greatly from year to year. When the income varies, your interest expense does not vary. So if you have a loan and you are paying interest, your interest does not change. Your sales might vary, your profit might varies, but your interest is fixed. Therefore, we have to evaluate how much of variance can we absorb as a company? So fixed interest charge can increase the risk that an owner will not earn a positive return and unable to pay interest. When you cannot pay your interest, you're in trouble. Why you're in trouble? Because they can sue you and they can force you to be out of business. They can force you to liquidate and they can put you out of business. So that's why the times earned or the times interest ratio or something that's called the time interest coverage. It means how much money do you have to cover your interest is an extremely important. And let me show you, let's look at a computation here for a sample company, Diego, for 2019. Their income before interest is 150, obviously before interest and taxes because you pay taxes last, divided by 60, they have interest coverage of two and a half times. So from their earnings, they can cover their interest 2.5 times. Now let's assume sales increase by $300. If sales increase by $300, what's gonna happen is your income before interest, it's gonna be 225, it's gonna be 225. And if we compute, if we take 225 divided by 60, your interest coverage becomes 3.75, which is good, that's good. But let's take a look if your sales decrease by 300. So in order to end from 600 to 900, then let's assume the same sales decrease. If your sales decrease, what's gonna happen now is you have interest, income before interest and tax of 75 and your interest expense stays the same, now the coverage is 1.25. Now you're getting really into trouble because you are barely covering your interest. So notice a 300 increase in your sales, that's good. You know, it's gonna improve your interest ratio, but 300 decrease, it might put you out of business. So when your income fluctuates a lot, it's very important to take into account the risk of the company, the risk on the interest expense. In the next, if you like this recording, please like it, share it, put it in playlist. And in the next recording, we would look at payroll related forms. As always, I would like to remind you to connect with me and visit my website for additional resources, especially if you're studying for your CPA exam during this coronavirus outbreak. Good luck and study hard.