Chapter one

Current Liabilities, Provisions, and

Contingencies
Nature and types of current liabilities
Liability is
Present obligation.
Arises from past events.
Results in an outflow of resources (cash, goods,
services).
Current liability
 are “obligations whose liquidation is reasonably
expected to require use of existing resources properly
classified as current assets, or the creation of other
current liabilities.
 is reported if one of two conditions exists:
1. The liability is expected to be settled within its
normal operating cycle; or
2. The liability is expected to be settled within 12
months after the reporting date.
The operating cycle
 is the period of time elapsing between the acquisition of
goods and services involved in the manufacturing
process and the final cash realization resulting from
sales and subsequent collections.
Current liability includes
 Accounts payable.
 Notes payable
 Current maturities of long-term debt
 Short-term obligations expected to be refinanced
 Dividends payable
 Customer advances and deposits
 Unearned revenues.
 Sales and value-added taxes
 Income taxes payable
 Employee-related liabilities
Accounts payable (trade accounts payable)
 are balances owed to others for goods,
supplies, or services purchased on open
account.
 arise because of the time lag between the
receipt of services or acquisition of title to
assets and the payment for them.
 The terms of the sale (e.g., 2/10, n/30 or 1/10,
E.O.M.) usually state this period of extended
credit, commonly 30 to 60 days.
Notes payable
are written promises to pay a certain sum of
money on a specified future date.
may arise from purchases, financing, or
other transactions.
usually require the borrower to pay interest.
Classified as short-term or long-term,
depending on the payment due date.
 may also be interest-bearing or zero-
interest-bearing.
Interest-Bearing Note Issued
state an interest rate on the face of the note.
Assume that Castle National Bank agrees to lend
$100,000 on March 1, 2020, to Landscape Co. if
Landscape signs a $100,000, 6 percent, four-month note.
a. How Landscape records the cash received on March 1?
b. If Landscape prepares financial statements semiannually,
what is the necessary adjusting entry?
c. If Landscape prepares financial statements monthly, its
adjusting entry at the end of each month is?
d. How Landscape records payment of the note and accrued
interest At maturity (July 1),
a. Landscape records the cash received on March 1 as
follows.
Cash 100,000
Notes Payable 100,000
b. If Landscape prepares financial statements
semiannually, it makes the following adjusting entry
Interest Expense 2,000
Interest Payable 2,00
$2,000 ($100,000 × .06 × 4/12) at June 30
C, If Landscape prepares financial statements monthly, its
adjusting entry at the end of each month is $500 ($100,000 ×
.06 × 1/12)
Interest Expense 500
Interest Payable 500
Zero-Interest-Bearing Note Issued
does not explicitly state an interest rate on the
face of the note. How ever Interest is still charged,
At maturity, the borrower
 must pay back an amount greater than the cash
received at the issuance date.
or receives in cash the present value of the note.
present value = face value of the note at maturity
- the interest or discount charged
the bank takes its fee “up front” rather than on the
date the note matures.
 borrower credits the Notes Payable account for the
present value of the note at the date of issuance .
At maturity must pay the face value of the note
To illustrate, assume that Landscape issues a
$102,000, four-month, zero-interest-bearing note to
Castle National Bank. The present value of the note is
$100,000.
a. How Landscape records this transaction on march 1?
b. If Landscape prepares financial statements
semiannually, what will be the adjusting entry?
c. At maturity (July 1, 2015) how Landscape record the
note payment?
Landscape records this transaction as follows.
March 1, 2015
Cash 100,000
Notes Payable 100,000
June 30, 2015
Interest Expense 2,000
Notes Payable 2,000
July 1, 2015
Notes Payable 102,000
Cash 102,000
Current Maturities of Long-Term Debt
 portion of bonds, mortgage notes, and other long-
term indebtedness that matures within the next
fiscal year.
reported as part of current liabilities.
 When only a part of a long-term debt is to be
paid within the next 12 months that retires
through a series of annual installments the
company reports
the maturing portion of long-term debt as a
current liability and
 the remaining portion as a long-term debt.
exclude long-term debts maturing currently as
current liabilities if they are to be:
i. Retired by assets accumulated for this purpose
that properly have not been shown as current
assets
ii. Refinanced, or retired from the proceeds of a new
long-term debt issue
iii. Converted into ordinary shares
Short-Term Obligations Expected to Be
Refinanced.
a company can exclude a short-term obligation
from current liabilities if both of the following
conditions are met:
i. It must intend to refinance the obligation on a
long-term basis; and
ii. It must have an unconditional right to defer
settlement of the liability for at least 12 months
after the reporting date.
Refinancing Criteria
Specifically, a company can exclude a short-term
obligation from current liabilities if both of the
following conditions are met:
1. It must intend to refinance the obligation on
a long-term basis; and
2. It must have an unconditional right to defer
settlement of the liability for at least 12
months after the reporting date
 Yong has a $50,000 short-term obligation
Illustration
due on March 1, 2015. The CFO discussed with its
lender whether the payment could be extended to
March 1, 2017, provided Yong agrees to provide
additional collateral. An agreement is reached on
February 1, 2015, to change the loan terms to
extend the obligation’s maturity to March 1, 2017.
The financial statements are authorized for
issuance on April 1, 2015
 Indicate how these transactions should be
reported at Dec. 31, 2014, on Yongs’ statement of
financial position.
• Since the agreement was not in place as of the
reporting date (December 31, 2014), the obligation
should be reported as a current liability.
assume that Haddad Company provides the following
information related to its note payable.
• Issued note payable of €3,000,000 on November 30,
2015, due on February 28, 2016. Haddad’s reporting
date is December 31, 2015.
• Haddad intends to extend the maturity date of the
loan (refinance the loan) to June 30, 2017.
• Its December 31, 2015, financial statements are
authorized for issue on March 15, 2016.
• The necessary paperwork to refinance the loan is
completed on January 15, 2016. Haddad did not have
unconditional right to defer settlement of the
obligation at December 31, 2015. how to classify
Liability of €3,000,000 at December 31,2015?
• A graphical representation of the refinancing events
is provided in

• In this case, Haddad must classify its note payable as

a current liability because the
refinancing was not completed by December 31,
2015, the financial reporting date.
 Only if the refinancing was completed before
December 31, 2015, can Haddad classify the note
obligation as non-current
Dividends Payable
A cash dividend payable is an amount owed by a
corporation to its shareholders as a result of
board of directors.
Because companies always pay cash dividends
within one year of, they classify them as current
liabilities.
On the other hand, companies do not recognize
accumulated but undeclared dividends on
cumulative preference shares as a liability. Why?
Because preference dividends in arrears are not an
obligation until the board of directors authorizes the
payment.
• Dividends payable in the form of additional
shares are not recognized as a liability. Because
 Such share dividends do not require future
outlays of assets or services.
 Reported in the equity section because they
represent retained earnings in the process of
transfer to share capital.
Sales and Value-Added Taxes Payable
Most countries have a consumption tax.
Consumption taxes are generally either a
sales tax or a value-added tax (VAT).
 The purpose of these taxes is to generate
revenue for the government.
 the objective of VAT and sales tax is to
tax the final consumer of the good or
service
 However, the two systems use different
methods to accomplish this objective.
Sales Taxes Payable
is collected only once at the consumer’s point of
purchase.
No one else in the production or supply chain is
involved in the collection of the tax.
assume that Halo Supermarket sells loaves of
bread to consumers on a given day for €2,400.
Assuming a sales tax rate of 10 percent, Halo
makes the following entry to record the sale.
Supermarket.
cash 2,640
Sales Revenue 2,400
Sales Taxes Payable 240(240*0.1)
Value-Added Taxes Payable
is a consumption tax
Is placed on a product or service whenever value
is added at a stage of production and at final sale
is collected every time a business purchases
products from another business in the product’s
supply chain.
 is easier to collect than a sales tax because it has
a self-correcting mechanism built into the tax
system.
 a disadvantage of a VAT is the increased amount
of record-keeping involved in implementing the
system.
• Example
1. Hill Farms Wheat Company grows wheat and
sells it to Sunshine Baking for €1,000 excluding
VAT. Hill Farms Wheat makes the following entry
to record the sale, assuming the VAT is 10 percent.
Cash 1,100
Sales Revenue 1,000
Value-Added Taxes Payable 100
 Hill Farms Wheat then remits the €100 to the
tax authority.
• Sunshine Baking makes loaves of bread from this
wheat and sells it to Halo Supermarket for €2,000.
Sunshine Baking makes the following entry to
record the sale, assuming the VAT is 10 percent
Cash 2,200
Sales Revenue 2,000
Value-Added Taxes Payable 200
Sunshine Baking then remits €100 to the
government, not €200. The reason: Sunshine Baking
has already paid €100 to Hill Farms Wheat. At this
point, the tax authority is only entitled to €100.
Sunshine Baking receives a credit for the VAT paid to
Hill Farms Wheat, which reduces the VAT payable.
3. Halo Supermarket sells the loaves of bread to
consumers for €2,400. Halo Supermarket makes the
following entry to record the sale, assuming the VAT
is 10 percent.
Cash 2,640
Sales Revenue 2,400
Value-Added Taxes Payable 240
• Halo Supermarket then sends only €40 to the tax
authority as it deducts the €200 VAT already paid
to Sunshine Baking.
 So who actually pays the VAT? It is the consumers who
bear the €240 VAT cost as part of their purchase price, not
the companies that produced and distributed the bread
A provision
is a liability of uncertain timing or amount
sometimes referred to as an estimated liability.
may be reported either as current or non-current
depending on the date of expected payment.
What is the difference between a provision and
other liabilities (such as accounts or notes
payable, salaries payable, and dividends
payable)? The difference is that provision
 has greater uncertainty about the timing
or amount of the future expenditure
required to settle the obligation.
Recognition of a Provision
Companies accrue an expense and related
liability for a provision only if the following
three conditions are met.
1. A company has a present obligation (legal or
constructive) as a result of a past event;
2. It is probable that an outflow of resources
embodying economic benefits will be required
to settle the obligation; and
3. A reliable estimate can be made of the amount
of the obligation.
 If these three conditions are not met, no
provision is recognized
In applying the second condition, the term probable
is defined as
– “more likely than not to occur.” means the probability
of occurrence is greater than 50 percent.
 If the probability is 50 percent or less, the provision is not
recognized.
Measurement of Provisions
IFRS states that The amount recognized
should be the best estimate of the expenditure
required to settle the present obligation.
Best estimate represents the
amount that a company would pay to settle the
obligation at the statement of financial position date
In determining the best estimate, the management
of a company must use
 judgment, based on past or similar
transactions,
 discussions with experts, and any
 other pertinent information.
Here are some common areas for which
provisions may be recognized in the financial
statements:
1. Lawsuits 4. Environmental
2. Warranties 5. Onerous contracts
3. Consideration payable 6. Restructuring
Litigation Provisions
 Companies must consider the following factors,
among others, in determining whether to record a
liability with respect to pending or threatened
litigation and actual or possible claims and
assessments.
1. The time period in which the underlying cause
of action occurred.
 To report a loss and a liability in the financial
statements, the cause for litigation must have
occurred on or before the date of the financial
statement.
2. The probability of an unfavorable outcome.
3. The ability to make a reasonable estimate of
the amount of loss.
Warranty Provisions
A warranty (product guarantee)
is a promise made by a seller to a buyer to make
good on a deficiency of quantity, quality, or
performance in a product.
used as a sales promotion technique for
Manufacturers .
 entail future costs.
 These additional costs, sometimes called
“after costs” or “post-sale costs,” frequently
are significant..
  Although the future cost is indefinite as to
amount, due date, and even customer, a
liability is probable in most case.
 Companies should recognize this liability in
the accounts if they can reasonably estimate it
 Thus, warranty costs are a classic example
of a provision.
Companies often provide one of two types of
warranties to customers:
1. Assurance-Type Warranty
2. Service-Type Warranty
1. Assurance-Type Warranty
Warranty that the product meets agreed-upon
specifications in the contract at the time the
product is sold.
is included in the sales price of a company’s
product
Companies do not record a separate
performance obligation.
obligations should be expensed in the period
the goods are provided or services performed(in
other words, at the point of sale).
 the company should record a warranty liability.
The estimated amount of the liability includes all
the costs that the company will incur after sale due
to the correction of defects or deficiencies required
under the warranty provisions.
Example Denson Machinery Company begins production
of a new machine in July 2015 and sells 100 of these
machines for $5,000 cash each by year-end. Each machine
is under warranty for one year. Denson estimates, based
on past experience with similar machines, that the
warranty cost will average $200 per unit. Further, as a
result of parts replacements and services performed in
compliance with machinery warranties, it incurs $4,000 in
warranty costs in 2015 and $16,000 in 2016.
Question: What are the journal entries for the sale
and the related warranty costs for 2015 and 2016?
2. Service-Type Warranty
Warranty that provides an additional service
beyond the assurance-type warranty.
is not included in the sales price of the product
is recorded as a separate performance obligation
provide the customer a service beyond fixing
defects that existed at the time of sale.
The sales of service type warranty is usually
recorded in an Unearned Warranty Revenue
account. Companies
o recognize revenue on a straight-line basis over
the period the service-type warranty is in effect
• You purchase an automobile from Hamlin Auto for
€30,000 on January 2, 2014. Hamlin estimates the
assurance-type warranty costs on the automobile
to be €700 (Hamlin will pay for repairs for the first
36,000 miles or three years, whichever comes
first). You also purchase for €900 a service-type
warranty for an additional three years or 36,000
miles. Hamlin incurs warranty costs related to the
assurance-type warranty of €500 in 2014 and €200
in 2015. Hamlin records revenue on the service-
type warranty on a straight-line basis.
What entries should Hamlin make in 2014 and 2017?
Environmental Provisions
 Estimates to clean up existing toxic waste sites
are substantial.
a company must recognize an environmental
liability
1. when it has an existing legal obligation
associated with the retirement of a long-
lived asset and
2. when it can reasonably estimate the
amount of the liability.\
Examples of existing legal obligations that require
recognition of a liability include but are not limited
to:
• Decommissioning nuclear facilities.
• Dismantling, restoring, and reclamation of
oil and gas properties.
• Certain closure, reclamation, and removal
costs of mining facilities.
• Closure and post closure costs of landfills.
A company initially measures an environmental
liability at the best estimate of its future costs
o The estimate should reflect the amount a
company would pay in an active market to
settle its obligation (essentially fair value).
o companies may use present value techniques
to estimate fair value.
 To record an environmental liability in the
financial statements(recognition),
o a company includes the cost associated
with the environmental liability in the
carrying amount of the related long-lived
asset, and
o records a liability for the same amount
 In subsequent periods (allocation),
o companies allocate the cost of the asset to expense
over the period of the related asset’s useful life
using straight-line method.
assume that on January 1, 2015, Wildcat Oil
Company erected an oil platform in the Gulf of
Mexico. Wildcat is legally required to dismantle
and remove the platform at the end of its useful
life, estimated to be five years. Wildcat estimates
that dismantling and removal will cost $1,000,000.
Based on a 10 percent discount rate, the fair value
of the environmental liability is estimated to be
$620,920 ($1,000,000 * .62092). Wildcat records
this liability as follows.
onerous contracts.
 are ones in which “the unavoidable costs of meeting
the obligations exceed the economic benefits
expected to be received.”
• assume that Sumart Sports operates profitably in a
factory that it has leased and on which it pays
monthly rentals. Sumart decides to relocate its
operations to another facility. However, the lease on
the old facility continues for the next three years.
Unfortunately, Sumart cannot cancel the lease nor
will it be able to sublet the factory to another party.
The expected costs to satisfy this onerous contract
are €200,000. In this case, Sumart makes the
following entry.
Loss on Lease Contract 200,000
Lease Contract Liability 200,000
• assume that Sumart Sports operates profitably
in a factory that it has leased and on which it
pays monthly rentals. Sumart decides to
relocate its operations to another facility.
However, the lease on the old facility continues
for the next three years. Unfortunately, Sumart
cannot cancel the lease nor will it be able to
sublet the factory to another party. The
expected costs to satisfy this onerous contract
are €200,000. In this case, Sumart makes the
following entry.
Loss on Lease Contract 200,000
Lease Contract Liability 200,000
The expected costs should reflect the least net
cost of exiting from the contract, which is the
lower of
1. the cost of fulfilling the contract, or
2. the compensation or penalties arising from
failure to fulfill the contract.
To illustrate, assume the same facts as above
for the Sumart example and the expected
costs to fulfill the contract are €200,000.
However, Sumart can cancel the lease by
paying a penalty of €175,000. In this case,
Sumart should record the liability at
€175,000.