Chapter one

Current liabilities and Contingencies

1. Definition of Liabilities
Liabilities are probable future scarifies of economic benefits arising from
present obligation of a company to transfer assets or provide services to
other entities in the future as a result of past transactions or events.
Main points of the definition (characteristics of liabilities).
Liabilities:
1. Are probable, future scarifies of economic benefits.
2. Arise from Present obligation to transfer assets or provide service
to others.
3. Result from past transaction or event, the transaction has already
happened.
Classification of liabilities: There are two major categories of liabilities,
these include:
 Long – term liabilities
 Short – term (current) liabilities
Current Liabilities: Current Liabilities are obligations whose liquidation
is expected to require the use of existing current assets or the creation of
other current liabilities with in one years or an operating cycle, which ever is
longer.
 Liquidated in one year/operation cycle.
 Required use of current asset or current liabilities
Classification of current liabilities: the primary types of current liabilities
are classified in three groups, as shown in the following.

Current Liabilities

Having Amounts depend Amount can

contractual on operations be estimated
amount

 A/Payable Sales taxes Property taxes

 N/Payable Payroll taxes Warranties
 Current Income taxes Premiums & Coupons
maturing Other Contingencies
porting of L.L 1
 Dividends pay.
 Accrued items
 Unearned item
1. Current Liabilities Having Contractual (Definite) Amount
These group result from the terms of contract or existence of law.
Characteristics
 Result from contracts or from existence of law
 The debt and its maturity are known with reasonable certainty
1. Trade Accounts Payable: Arise from purchase of inventory, supplies or
services on an open charge account basis:
The purchaser should record both the purchase (inventory) and
the liabilities in the accounting period in which the economic
control (and legal title co. to the goods passes to him/her.
On other words the company records the liabilities when it
receives invoice from the suppliers.
The following issues need special attention:
1. For goods in transit at the end of year,
If purchased at FOB shipping point, liability and purchase
should be recorded in the accounting period of purchase.
If they are purchased under FOB destination, the purchase and
the liability must be recorded in the accounting period in which
goods are received by the purchaser.
2. When cash discount is involved in the purchase transaction, accounts
payable may be recorded in two different ways.
Theoretically, a Company show inventory (purchase) as the associated
accounts payable less the trade discount.
1. Gross price method: That is, at the invoice price - the liability is
stated at the maximum amount required to be paid.
2. Net price method: That is, the at the invoice price less the cash
discount the liability is stated at its current cash equivalent amount.
2. Note Payable
A note payable is an unconditional written agreement to pay a sum of money
to the bearer on specific date. Notes payable may be either short - term or
long - term. Short term notes payable is also classified as (a) interest
bearing (b) non - interest bearing.
a) Issuance of Interest – bearing note
Interest – bearing note: Characteristics of the note include:
Principle amount (face value) is the present value of the liabilities.
Interest is separately stated from the face value.
The face value is used to record the liabilities
Interest is recorded over the life of the note.

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Example: Assume Galaxy Company used perpetual inventory system and
purchase merchandise for $10,000 on Oct. 31, 2004, by issuing a
$10,000, 12% 90-day note to the supplier. Accounting period
end on Dec. 31. (use 360 – day year).
Entries
1. To record issuance of the note (Gross)
Inventory .............................. 10,0000
Notes payable............................. 10,000
Dec. 31, 2004 end of year: Adjustment of accrued interest
Adjustment of accrued interest.
Accrued interest =60/360 x 12/100 x 10,000 = 200
Interest expense ............................... 200
Interest payable .................................. 200
(closing entry is assumed)
Note: The interest payable reported is as current liability.
Jan. 1, 2005 Reversing
Interest Pay .................................. 200
Interest expense.................................. 200
Due date
Total interest (90 days) =90/360 x 12/100 x 10,000
= 300
Entries:
Note payable ............................... 10,000
Interest expense ........................ 300
Cash ......................................................... 10,300

3. Currently Maturing portion of long - term liabilities

The following are considered to be current liability on the balance sheet:
a) A term bond to become due (retired with in one year of the
balance sheet date.
Example: If a Company issues a 5-year bond on Jan. 1, 2001 for $100,000
Its maturity date = Dec. 31,2005
Thus during 2001 – 2005 the total value is long – term liabilities.
On balance sheet of Dec. 31,2004 to be prepared immediately before
the year of retirement, the liability will be current liability.
B) Issuance of Serial bonds: Bonds that are retired in periodic
installments.
Example: On Jan. 1, 1999 Relax Corporation issues 13% serial bonds with
the face value of $1,000,000 which will be retired in installments of $100,000

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beginning July 1,2000, and each year therefore until all bonds are retired.
On balance sheet of Dec. 31,1999:
Current liability: Amount to be repaid on July1, 2000, $100,000
Long - term liability: This consists of $900,000 which is installment
due after Dec. 2000.
4. Dividends payable
Types of dividends & dividends payable
Cash dividend - Payable in cash
Property dividend - Payable in property other than cash
Scrip dividend - Creates a promissory note
When dividend is declared, it reduce Retained Earnings and a current liability
is created if there is an intention to distribute the dividend in the coming
year.
Entry Retained earnings (amount to be paid).............. xxx
Dividends payable ............................................. xxx
Normal Dividends payable is reported as current liability

Exception
1. A Company does not report a stock dividend to be issued as current
liability since a stock dividend is liquidated by the issuance of the
corporation’s own stock; it is reported as an element of Shareholders’
equity.
2. Only disclosure is needed for undeclared dividends on cumulative
preferred stock.
5. Accrued Liabilities
Accrued liabilities represent obligations that accumulate in a systematic way
over time.
Accrued liabilities are recorded with the help of adjusting entry at the
end of each accounting period.
Example: See adjusting entry for interest expense in the previous section of
this chapter (unit).
6. Unearned Items (Deferred revenue)
These include amounts that a company has collected in advance but has not
yet been earned and has not recorded as revenue (i.e., the company has not
yet provided the product or service)

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Examples: Include amounts collected in advance for the following.

Interest Classified as Current liability

Rent if they are to be settled in
one year or accounting
Magazine subscription
period.
Service contracts etc
II. Current Liability whose Amount Depend on Operations
These are obligation related to operation & their amount depends on these
operations.
Example: Liabilities under this category include:
Sales tax
Income tax (payroll taxes)
Bonus agreement
a) Sales Tax
A sales tax is a tax levied on the transfer of tangible personal property and
certain services.
A seller must collect sales tax from customer and remit the amount to the
proper government authority. The un-remitted sales tax is a liability to the
seller until it is remitted.
Accounting for sales tax: There are two alternative accounting
treatments of s ales tax.
i. Sales Tax added to the invoice price
Sales tax and sales amount are separately known and the Company
records them in respective account.
Example: A company sold mdse for cash for $60,000 on which a sales tax of
5% is levied.
Cash collected
Invoice price ........................... 60,000
Sales tax 5/100 x 60,000........... 3,000
Total ...................................... 63,000
Entry:
Cash ............................ 63,000
Sales ................................... 60,000
Sales tax payable ................. 3,000
Sales tax payable is reported as current liability in the balance
sheet.
ii) The balance includes the amount of sales tax directly in the price
of merchandise

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 The Company credits sales accounts for the sum of sales amount and
sales tax amount
At the end of the month an adjusting entry is made to reduce sales
account and to create the current liability, Sales tax pay.
Sales amount = The amount in sales account
1 + sales tax rate
Sales tax = Amount in sales account – Sales amount as calculated above

Example: At the beginning of January ABC Company sold mdse, for cash. It
received $169,600 & credited sales account by $169,600. The
amount include sales (tax of 6% on sales)
Jan. 1. Cash ..................................... 169,600
Sales ......................................... 169,600
Jan. 31, Adjustment
 Sales amount 169,600 = 160,000
1.06
 Sales tax = 169,600 – 160,000 = 9,600

Sales ............................................ 9,600

Sales tax payable ............................. 9,600
b) Bonus Obligations
The Company records the bonus as an expense and as a current liability
when it has been earned by the employees. Furthermore, the company
deducts the bonus payments when computing its taxable income.
Example: Assume that Selam Bus Line has a bonus plan under which a
branch manager receives 20% of the income over $20,000 earned by the
branch. Income for a given branch amounts to $80,000 before the bonus
and income tax. Assume income tax are 40% of the pre- tax income.
Required: Find bonus amount under the following independent plans:
1. Bonus is based on income before income tax and bonus.
2. Bonus is based on income after bonus but before income tax.
3. Bonus is based on net income.
4. Bonus is based on income before bonus and after income tax.
Solution: Plan 1
Bonus = BR (income subject to Bonus)
= 0.2 (80,000 – 20,000) = 12,000
Plan 2: Bonus is to be computed on income in excess of 20,000 after
bonus.

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 B = 0.2 (80,000 – 20,000 – B)
B = 16,000 – 4,000 – 0.2 B
B + 0.2B = 12,000
1.2B = 12,000
B = 12,000 = 10,000
1.2
Plan 3: Bonus is to be computed on net income (net income after both
bonus & tax)
B = 0.2 (80,000 – 20,000 – T – B), T = 0.4 (80,000 – B)
B = 0.2 [60,000 – 0.4 (80,000 – B) – B]
= 0.2 [60,000 – 32,000 + 0.4B – B]
B = 12,000 – 6,400 + 0.08B – 0.2B
B = 5,600 – 0.12B
1.12B = 5,600

B = 5,600 = 5,000
1.12

Entry (for plan 3)

Bonus expense ................................ 5,000
Bonus payable................................... 5,000
Plan 4: Bonus is to be calculated after deducting income tax but before
bonus
B = 0.2 (80,000 – 20,000 – T) , T = 0.4 (80,000 – B)
B = 0.2 (60,000 – 0.4(80,000 – B)
B = 0.2(60,000 – 32,000 + 0.4B)
B = 12,000 -6400+ 0.08B
B = 5,600 + 0.08B
0.92B = 5,600
B = 5,600 = 6086.9565 = 6,087
0.92

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III Amount can be estimated
A Warranty Obligation
Product warranty agreements require the seller, over a specified period of
time, after the sale, to correct any deficiencies in quality, quantity, or
performance of the merchandise sold, to replace the item, or to refund the
selling price.
Adherence to the matching principle requires that a company recognize the
warranty expense in the period in which it makes the sale
Methods of Accounting for Warranty cost
There are two methods of accounting for warranty costs:
1. Expense warranty accrual method
2. Sales warranty accrual method
Expense Warranty Accrual Method
Under this method a company recognizes the estimated warranty expense
and liability for future performance under the warranty in the period of sale.

This method assumes that the company makes the warranty offer to
increase sales, here the estimated warranty expense is matched against
these sales.

Example: AMC Corporation begins production on a new machine in April

2001, and sells 200 of these machine at $6,000 each by Dec. 2001. Each
machine carries a warranty for one year. Experience from the sale of similar
machinery in the past has shown that the warranty costs will average $150
per unit or a total of $30,000 (200 x $150). The Corporation spent $5,000 in
warranty agreement for 200 machines sold in 2001 and $25,150 in 2002.
Entry:
1. Sales of 200 machines during April – Dec. 2001
Cash (A/R) ................................ 1,200,000
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 Sales (6,000 x 200)............................... 1,200,000
2. Reorganization of warranty expense for period of April – Dec. 2001
Warranty Expense........................... 30,000
Estimate liability under warranty .............. 30,000
3. Payment or Incurrence of warranty costs for the period of, April – Dec.
2001.
Estimated liability under warranty ............ 5,000
Cash (or other assets)........................................ 5,000
4. Balance sheet Dec. 31, 2001 & Income statement
 The estimate liability under warranty (30,000 – 5000= 25,000) is
reported as current liability
 Warranty Expense: reported as operating expense in the Income
Statement.
5. Payment or Incurrence of warranty costs in 2002
Estimated liability under warranty ............. 25,000
Warranty expense...................................... 150
Cash (or other assets)...................................... 25,150

Sales Warranty Accrual Method

This method assumes that sales price of each product includes the sales of
two items:
1. The product and
2. An implied warranty cost

A company assumes that its revenue from implied warranty contract is equal
to the estimated warranty costs, and it defers and recognizes revenue
amount that equal to the warranty costs incurred.

In essence, this is a cost recovery approach to warranty revenue recognition.

Example: See the above example

Sales of warranty $150

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Sales price per unit of $6,000 consists

Sales of machine (6,000 –

150) = 5850
Entries
1. Sales of 200 machines, April – Dec. 2001
Cash or A/R (6,000 x 200)..................... 1,200,000
Sales ($5,850 x 200)..................................... 1,170,000
Unearned Warranty Rev ($150 x 200) ........... 30,000

2. Recognition of Warranty Expense, April – Dec. 2001

Warranty expense .............................. 5,000
Cash or other Assets.................................. 5,000

3. Recognition of Warranty revenue, April – Dec. 2001

Unearned Warranty Revenue 5,000
Warranty Revenue 5,000

Financial statement Presentation

Balance Sheet: Unearned warranty revenue is reported as current
liability.

Income Statement: the warranty expense warranty revenue are

reported in the income statement as usual.

Warranty Expense....................... 5,000

Warranty revenue....................... 5,000

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Comparison of Net income in the two methods

Expense Sales
warranty Warranty
Revenue
Sales 1,200,000 1,170,000
Sales W. - 5,000
revenue
1,200,000 1,175,000
Warranty Expense 30,000 5,000
1,170,000 1,170,000

2002
1. Recognition of Warranty Expense
Warranty expense ............................... 25,150
Cash ...................................................... 25,150

2. Recognition of Warranty Revenue

Unearned Warranty revenue ...................... 25,000
Warranty Revenue ................................. 25,000

Note: 1) No profit is realized from the sale of the implied warranty contract
2) In the above example there is a loss of $150. This loss results from
the actual warranty costs exceeding the estimated costs by that
amount.

3. Contingencies
Contingency is defined as: An existing condition, situation, or set of
circumstances involving uncertainty as to possible gain (gain contingency) or
loss (loss contingency) to (a company) that will be resolved when one or
more future events occur or fail to occur. Resolution of the uncertainty may
confirm the acquisition of an asset or the reduction of liability or the loss or
the loss in currency of a liability.
The definition includes three primary characteristics of contingency:
1. An existing condition

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 2. Uncertainty as to the ultimate effect of this condition, and
3. Resolution of the uncertainty based on one or more future events
1. Accounting for contingencies
A loss contingency is recognized if the future event is probable and if its
amount can be reasonable estimated. If these two criteria are met, a
company records a loss contingency by debiting an expense (or loss) and
crediting a liability (or a contra asset).
The following are examples of loss contingencies to be accrued.
 Warranty expense /product warranty/
 Premium expense /Premium offers/
 Collectibles of accounts receivable
 Sales returns and allowances
 Obligations related to property tax

Example 1
Assume a Company estimates that its bad debts expense is $15,000 for
2004. The Company records this loss contingency at the end of the year as
follows:
Bad debts expense ...................................... 15,000
Allowance for doubtful accounts .......................... 15,000
2. Disclosure in Notes to Financial Statements
A Company discloses a loss contingency in the notes to its financial
statements if one or both of the preceding conditions (probable event and
reasonably estimated amount), are not met and if there is reasonable
probability that the company may have incurred a loss.
Examples of loss contingencies to be disclosed include:
 Direct and indirect guarantee of indebtedness of others
 Obligations of Commercial Bank under “standby letter of credit”,
3. Disclosure of a gain Contingency
A gain contingency is not recorded, a company discloses a gain contingency
in the notes to its financial statements, due to the conservatism principle.
Example of gain contingencies include:
 Where a company is saving another company for patent infringement,
and the probability of willing the suit is excellent.
 A probable expropriation of a company’s property by a foreign
government where probable reimbursement will exceed the book value
of the property expected to be taken over by the foreign government.

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