Chapter 2: Current Liabilities, Provisions, and Contingencies

After studying this chapter, you should be able to:

Objectives
Learning

1. Describe the nature, type, and valuation of current liabilities.

2. Identify the criteria used to account for and disclose gain and loss contingencies.
3. Explain the accounting for different types of loss contingencies.
4. Indicate how to present liabilities and contingencies.

In this chapter, the basic issues related to accounting and reporting for current and contingent liabilities are
explained.

2.1. Nature and Types of Current Liabilities

FASB [in its conceptual framework], defined liabilities as “probable future sacrifices of economic benefits
arising from present obligations of a particular entity to transfer assets or provide services to other entities
in the future as a result of past transactions or events.”

A liability has three essential characteristics:

 It is a present obligation that entails settlement by probable future transfer or use of cash, goods, or
services.
 It is an unavoidable obligation.
 The transaction or other event creating the obligation has already occurred.

Because liabilities involve future disbursements of assets or services, one of their most important features is
the date on which they are payable. A company must satisfy currently maturing obligations in the ordinary
course of business to continue operating. Liabilities with a more distant due date do not, as a rule, represent a
claim on the company’s current resources. This feature gives rise to the basic division of liabilities into (1)
current liabilities and (2) long-term debt.

Current liabilities 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”. This definition
has gained wide acceptance because it recognizes operating cycles of varying lengths in different industries.
This definition also considers the important relationship between current assets and current liabilities.

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.

Here are some typical current liabilities:

 Accounts payable.  Sales taxes payable.
 Notes payable.  Employee-related liabilities.
 Current maturities of long-term debt.  Income taxes payable.
 Dividends payable.  Short-term obligations expected to be
 Customer advances and deposits. refinanced.
 Unearned revenues.
Some of these are discussed below.

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Accounts Payables are the amounts due to suppliers relating to the purchase of goods and services. This is
perhaps the simplest and most easily understood current liability. Although an account payable may be
supported by a written agreement, it is more typically based on an informal working relation where credit
has been received with the expectation of making payment in the very near term.

Notes Payables are formal short-term borrowings usually evidenced by specific written promises to pay.
Bank borrowings, equipment purchases, and some credit purchases from suppliers involve such
instruments. The party who agrees to pay is termed the “maker” of the note. Properly constructed, a note
payable becomes a negotiable instrument, enabling the holder of the note to transfer it to someone else.
Notes payable typically involve interest, and their duration varies. When a note is due in less than one
year (or the operating cycle, if longer), it is commonly reported as a current liability.

The Current Portion of Long-term Debt is another frequently encountered current obligation. When a note
or other debt instrument is of long duration, it is reported as a long-term liability. However, the amount of
principal which is to be paid within one year or the operating cycle, whichever is longer, should be
separated and classified as a current liability. For example, a $100,000 long-term note may be paid in
equal annual increments of $10,000, plus accrued interest. At the end of any given year, the $10,000
principal due during the following year should be reported as a current liability (along with any accrued
interest), with the remaining balance shown as a long-term liability.

Accrued Liabilities (sometimes called accrued expenses) include items like accrued salaries and wages,
taxes, interest, and so forth. These items relate to expenses that accumulate with the passage of time but
will be paid in one lump-sum amount. For example, the cost of employee service accrues gradually with
the passage of time. The amount that employees have earned but not been paid is termed accrued salaries
and should be reported as a current liability. Likewise, interest on a loan is based on the period of time the
debt is outstanding; it is the passage of time that causes the interest payable to accrue. Accrued but unpaid
interest is another example of an accrued current liability. The reported accrued liabilities only relate to
amounts already accumulated and not to amounts that will arise later.

Prepayments by Customers arise from transactions such as selling magazine subscriptions in advance,
selling gift-cards, selling tickets well before a scheduled event, and other similar items where the
customer deposits money in advance of receiving the expected good or service. These items represent an
obligation on the part of the seller to either return the money or deliver a service in the future. As such,
the prepayment is reported as “unearned revenue” within the current liability section of the balance sheet.
Recall, from earlier discussions in principles of accounting, that the unearned revenue is removed and
revenue is recognized as the goods and services are provided.

Collections for Third Parties arise when the recipient of some payment is not the beneficiary of the
payment. As such, the recipient has an obligation to turn the money over to another entity. At first, this
may seem odd. But, consider sales taxes. The seller of merchandise must collect the sales tax on
transactions, but then has a duty to pass those amounts along to the appropriate taxing body. Such
amounts are appropriately reflected as a current liability until the funds are remitted to the rightful owner.

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Obligations to be Refinanced deserves special consideration. A long-term debt may have an upcoming
maturity date within the next year. Ordinarily, this note would be moved to the current liability section.
However, companies often renew such obligations, in essence, borrowing money to repay the maturing
note. Should currently maturing long-term debt that is subject to refinancing be revealed as a current or a
long-term liability? To resolve this issue, accountants have developed very specific rules. A currently
maturing long-term obligation is to be shown as a current liability unless (1) the company intends to
renew the debt on a long-term basis and (2) the company has the ability to do so (ordinarily evidenced by
a firm agreement with a competent lender).

2.2. Recognition and Measurement of Current Liabilities

Categories of current liabilities:
 Definitely measureable liabilities
 Liabilities whose amount is estimated
 Liabilities dependent on operating results

Definitely Measureable Liabilities

Liabilities in this category are the result of contracts or the operation of federal or state statutes such that
the amount of an obligation and its due date are known with the reasonable certainty. The accounting
problems are to ascertain that an obligation exists, to measure it as accurately as possible, and to enter it
in the accounting records. The most common examples of this category are trade accounts payable and
promissory note (notes payable).

A) Accounts payable
Accounts payable represent trade payables, those obligations that exist based on the good faith credit of
the business or owner, and for which a formal note has not been signed. Purchases of merchandise or
supplies on an account are examples of liabilities recorded as accounts payable. The credit terms of each
transaction and the company’s ability to take advantage of available discounts determine the timing of
payments of accounts payable balances.

To illustrate, assume the following activity relating to trade accounts payable for current year:
(a) Purchased $900,000 of merchandise on terms of 2/10, n/30.
(b) Paid invoice for purchases of $600,000 within the discount period and for purchases of $100,000
after the discount period lapsed.
(c) Estimated at the end of the year that 25% of the $200,000 outstanding trade accounts payable would
not be paid within the discount period.

The journal entries for the year and presentation of trade accounts payable in the balance sheet at the end
of the year under the two alternative approaches are presented below:

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 Face amount method Net purchase method
(1) Purchases 900,000 Purchases* 882,000
Trade A/P 900,000 Trade A/P 882,000

(2) Trade A/P 700,000 Trade A/P** 686,000

Cash 688,000 Purchase discount Lost # 2,000
Purchase discount @ 12,000 Cash 688,000

(3) AFPD 3,0000 Purchase discount Lost## 1,000

Purchase discount 3,000 Trade A/P 1,000

Note:
@ ($600,000*0.02) = $12,000 * ($900,000*0.98) = $882,000
AFPD = allowance for purchases discount **($700,000*0.98) = $688,000
# ($100,000*0.02) = $2,000
##($200,000*0.25*0.02) = $1,000

Presentation in the balance sheet at the end of the year:

Trade A/P $200,000 Trade A/P $197,000
Less: AFPD (3,000)
Carrying amount of Trade A/P $197,000

B) Notes Payable
Notes Payables are written promises to pay a certain sum of money on a specified future date. Notes
payable that arise from cash-borrowing activities are generally of two types: (1) Interest-bearing notes,
and (2) Zero-interest-bearing (Noninterest-bearing) notes. Accounting and reporting for interest-bearing
notes requires the accountant to accrue interest and report a liability in the amount of the accrued interest
payable plus the face value of the note. Noninterest-bearing notes do not pay any stated rate of interest in
addition to the face amount of the notes. The lender deducts interest on such notes in advance and issues
the notes at discount. The borrower receives an amount that is less than the face value of the note (e.g.,
receives in cash the PV of the note).

Long-term notes will be considered in the next chapter. For the moment, the focus is on the appropriate
accounting for a short-term note. A common scenario would entail the borrowing of money in exchange
for the issuance of a promissory note payable. The note will look something like this:
ABC Inc.
Promissory Note
For value received, the undersigned promises to pay to the order of ABC Inc. the sum of:

*****$10,000 (Ten-Thousand and no/100 Dollars)*****

Along with annual interest of 12% on the unpaid balance. This note shall mature and be payable, along
with accrued interest, on December 19, 2014.

June 20, 2014 Mr. John D

Issue Date Maker signature

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The preceding illustration should not be used as a model for constructing a legal document; it is merely an
abbreviated form to focus on the accounting issues. A correct legal form would typically be far more
expansive and cover numerous things like what happens in the event of default, which pays legal fees if
there is a dispute, requirements of demand and notice, and so forth. In the preceding note, Mr. John has
agreed to pay to ABC Inc. $10,000 plus interest of $600 on December 19, 2014. The interest represents
12% of $10,000 for 180 days (June 20 through December 19). The amount borrowed is recorded by
debiting Cash and crediting Notes Payable:
June 20 Cash $10,000
2014 Note payable $10,000
To record Note payable maturing on December 19, 2014.

When the note is repaid, the difference between the carrying amount of the note and the cash necessary to
repay that note is reported as interest expense. The journal entry follows:
Dec. 19 Interest expense $600
2014 Note payable 10,000
Cash $10,600
To record the repayment of Note and interest ($10,000*12%*180/360)

Interest-Bearing Notes Payable-Illustration

Given: Larson Corporation borrows $100,000, signs a 4-month, 12% notes on March 1 – record journal
entries:
 Signing of note
 Interest accrual at June 30 year end and
 Note repayment
Solution:
March 1: Cash 100,000
Notes Payable 100,000

June 30: Interest Expense 4,000

Interest Payable (100,000 x 12% x 4/12) 4,000

July 1: Notes Payable 100,000

Interest Payable 4,000
Cash 104,000

Noninterest-Bearing Notes Payable

Many students will be familiar with the saying, “There is no such thing as a free lunch!” Notes that truly
have no interest charged are just as rare. For example, if a company borrows cash from a bank by signing
a noninterest-bearing note, the interest is simply deducted from the cash proceeds received on the note. At
maturity, only the face value of the note is repaid. Therefore, interest is deducted up front, rather than paid
at the end. This is similar to the process of discounting a note receivable, which was presented in
Financial Accounting part one.

The steps to account for a noninterest-bearing note are as follows:

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Step 1: Calculate the Discount on the Note
The discount on a noninterest-bearing note is computed using the following formula:
Discount = Face Amount of Note  Discount Rate  Time Period

The discount rate is the interest rate being charged on the note. For example, assume that ABC Company
borrows $7,500 by signing a 90-day noninterest-bearing note. The bank discounts the note at 12%. (The
bank is charging 12% interest.) The discount on this note is: $7,500  12%  90/360 = $225.

Step 2: Calculate the Cash Proceeds Received on the Note

The cash that ABC Company will receive is computed by subtracting the discount from the face amount
of the note. After the bank deducts the discount, ABC Company will receive $7,275 ($7,500 – $225).

Step 3: Record the Liability Resulting from the Note and the Cash Received
ABC must record the note payable at its full face amount, since this is the amount to be repaid in 90 days.
The discount retained by the bank is recorded as Interest Expense. The journal entry for this transaction
is:
Cash 7,275
Interest Expense 225
Notes Payable 7,500

Step 4: Record Payment When the Note Matures

ABC off will repay the full $7,500 when the note becomes due. Since the interest on the note has already
been recorded, the journal entry at that time is:
Notes Payable 7,500
Cash 7,500

Noninterest-Bearing Notes Payable-Illustration

To illustrate the accounting for promissory notes payable issued at discount, assume that on January 1,
2011 KK Company issues a one-year non-interest-bearing note for the acquisition of office equipment.
The face amount of the note is $150,000 and the current fair rate of interest on the note is 12%,
compounded quarterly.
Required:
(a) Determine the present value of the note and discount amount.
(b) Record the necessary journal entries at the time of issue and for interest expense on quarterly basis.
(c) Show the balance sheet presentation of the note for each quarter.

Solution:
PV = FV/ (1+i) n

Where, PV= present value,

FV= future value,
i= quarterly discount rate (12%/4 = 3%) and
n= number of intervals (quarters) in a year (4 quarters)
PV = $150,000/ (1+0.03)4 = $133,273  is also the price of office equipment.

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 Or PV = $150,000*0.888487 = $133,273
Discount = FV - PV $150,000-$133,273 = $16,727

Journal entry at the time of issuing the note:

Jan 1 Office equipment $133,273
2011 Discount on notes payable 16,727
Notes payable $150,000

Partial balance sheet presentation immediately after issuance-January 1, 2011:

Current Liabilities
Notes payable $150,000
Less: Discount on notes payable 16,727
Notes payable, net $133,273

At the end of the first quarter (March 31, 2011), interest expense is $3,998 = ($133,273*12%*3/12).
Journal entry to recognize interest expense on the same date is as follow:
Mar 31 Interest expense $3,998
2011 Discount on notes payable $3,998

Partial balance sheet presentation on March 31, 2011:

Current Liabilities
Notes payable $150,000
Less: Discount on notes payable 12,729
Notes payable, net $137,271

At the end of the second quarter (June 30, 2011), interest expense is $4,118 = ($137,271*12%*3/12).
Journal entry to recognize interest expense on the same date is as follow:

June 30 Interest expense $4,118

2011 Discount on notes payable $4,118

Partial balance sheet presentation on June 30, 2011:

Current Liabilities
Notes payable $150,000
Less: Discount on notes payable 8,611
Notes payable, net $141,389

At the end of the third quarter (September 30, 2011), interest expense is $4,242 = ($141,389*12%*3/12).
Journal entry to recognize interest expense on the same date is as follow:

Sept. 30 Interest expense $4,242

2011 Discount on notes payable $4,242

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Partial balance sheet presentation on September 30, 2011:
Current Liabilities
Notes payable $150,000
Less: Discount on notes payable 4,369
Notes payable, net $145,631

At the end of the last (4th) quarter (December 31, 2011), interest expense is $4,369 =
($145,631*12%*3/12). Journal entry to recognize interest expense on the same date is as follow:
Dec. 31 Interest expense $4,369
2011 Discount on notes payable $4,369

Partial balance sheet presentation on December 31, 2011:

Current Liabilities
Notes payable $150,000
Less: Discount on notes payable 0
Notes payable, net $150,000

Liabilities Whose Amount are Estimated

Liabilities of this category are estimated with respect to their amount. For instance, property taxes are
based on the assessed value of real and personal property and usually represent the primary source of
revenue for local governmental units. Legally, property taxes arise as of particular date, usually on the
lien date, the date taxes become a lien against the property. The two accounting issues relating property
taxes are: (1) When should the liability for property taxes be recorded? And (2) To which accounting
period does the tax expense relate?

Because the legal liability for property taxes arises on the lien date, the liability may be recorded on that
date. However, AICPA took the position that accrual of property taxes during the fiscal year of taxing
units generally is the most acceptable method.

To illustrate, assume that MM Company's plant assets are subject to property taxes by local taxing units.
The fiscal years of the local taxing units cover the period from July 1 to June 30. Property taxes of
$36,000 are assessed on March 15, 2011, covering the fiscal year starting on July 1, 2011. The lien date is
July 1, 2011, and taxes are payable in two installment of $18,000 each on December 10, 2011 and on
April 10, 2012. The accounting for property taxes for the period from July 1, 2011 to June 30, 2012,
assuming that MM Company accrues the property taxes monthly, is presented below:

Explanation Journal entries

July 1, 2011 Liability of $36,000 comes into No journal entry required.
existence on July 1, 2011, the lien date.
At the end of July, August, September, October Property taxes expense ($36,000/12) 3,000
and November, 2011 to record monthly property Property taxes payable 3,000
taxes expense.

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Dec. 10, 2011 To record payment of 1st installment Property taxes payable ($3,000*5) 15,000
of property tax bill. Prepaid Property taxes 3,000
Cash 18,000

Dec. 31, 2011 To record monthly property taxes Property taxes expense 3,000
expense. Prepaid Property taxes 3,000

At the end of January, February, and March, 2012, Property taxes expense ($36,000/12) 3,000
To record monthly property taxes expense. Property taxes payable 3,000

April 10, 2012, To record payment of 2 nd Property taxes payable ($3,000*3) 9,000
installment of property tax bill. Prepaid Property taxes 9,000
Cash 18,000

At the end of April. May, and June 30, 2012, To Property taxes expense 3,000
record monthly property taxes expense. Prepaid Property taxes 3,000

Liabilities Dependent on Operating Results

The amount of certain obligations cannot be measured until operating results are known. These include
income taxes, bonuses, profit-sharing distributions, and royalties. There is no particular accounting
problem in determining such liabilities at the end of fiscal year, when the operating results are known.
However, difficulties may arise in estimating such obligations for interim reports.

Bonuses and Profit-Sharing

Contracts covering rents, royalties, or employee compensation sometimes requires conditional payments
in an amount dependent on revenue or income for an accounting period. Let's use bonus to describe
conditional payment of this type. Some bonus plans provide for a bonus based on income. The plans
generally are drawn so that the income amount used to compute the bonus is clearly defined. For
example, the bonus may be based on:
(1) Income before income taxes and bonus
(2) Income after bonus but before income taxes or
(3) Net income

To illustrate, assume that Larson Company has a bonus plan under which a branch manager receives 20%
of the income over $20,000 earned by the branch. Income for the branch amounted to $80,000 before the
bonus and income taxes. Assume for the purpose of illustration that income taxes are 40% of pre- tax
income. The bonus under each of the three plans listed above is computed as follows.
Plan 1 The bonus is based on income in excess of $20,000 before deduction of income taxes and the
bonus:
Bonus = 0.2 ($80,000 - $20,000) = $12,000

Plan 2 The bonus is based on income in excess of $20,000 after deduction of the bonus but before
deduction of income taxes:
B = Bonus
B = 0.2 ($80,000 - $20,000 - B)

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 B = $16,000 - $4,000 - 0.2B
1.2B = $12,000
B = $10,000

Plan 3 The bonus is based on net income in excess of $20,000 after deduction of both bonus and income
taxes:
B = Bonus
T = Income taxes
B = 0.2 ($80,000 - $20,000 -T- B)
T = 0.4 ($80,000 - B)substituting for T in the first equation, the bonus is computed as follows:
B = 0.2 ($80,000 - $20,000 - 0.4 ($80,000 - B) - B)
B = $12,000 - $6,400 + 0.08B - 0.2B
1.12B = $5,600
B = $5,000

Journal entry to record bonus:

Bonus Expense 5,000
Bonus Payable 5,000

2.3. Contingencies and Provisions

Accounting for Contingent Liabilities
A contingency is an existing condition, a situation, or a set of circumstances involving uncertainty as to
possible gain (gain contingency) or loss (loss contingency) to a business enterprise that ultimately will be
resolved when a future event or events occurs or fails to occur. A subjective assessment of the probability
of an unfavorable outcome is required to properly account for most contingences. Rules specify that
contingent liabilities should be recorded in the accounts when it is probable that the future event will
occur and the amount of the liability can be reasonably estimated. This means that a loss would be
recorded (debit) and a liability established (credit) in advance of the settlement.

On the other hand, if it is only reasonably possible that the contingent liability will become a real
liability, then a note to the financial statements is required. Likewise, a note is required when it is
probable a loss has occurred but the amount simply cannot be estimated. Normally, accounting tends to be
very conservative (when in doubt, book the liability), but this is not the case for contingent liabilities.
Therefore, one should carefully read the notes to the financial statements before investing or loaning
money to a company.

There are sometimes significant risks that are simply not in the liability section of the balance sheet. Most
recognized contingencies are those meeting the rather strict criteria of “probable” and “reasonably
estimable”. One exception occurs for contingencies assumed in a business acquisition. Acquired
contingencies are recorded based on an estimate of actual value. What about remote risks, like a frivolous
lawsuit? Remote risks need not be disclosed; they are viewed as needless clutter. What about business
decision risks, like deciding to reduce insurance coverage because of the high cost of the insurance
premiums? GAAP is not very clear on this subject; such disclosures are not required, but are not
discouraged. What about contingent assets/gains, like a company’s claim against another for patent

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infringement? Such amounts are almost never recognized before settlement payments are actually
received.
 Both IFRS and GAAP prohibit the recognition of liabilities for future losses.
 IFRS uses the term provisions to refer to estimated liabilities.
 Under IFRS, contingencies are not recorded but are often disclosed.
 The accounting for provisions under IFRS and estimated liabilities under GAAP are very similar.

Typical Gain Contingencies are:

 Possible receipts of monies from gifts, donations, and bonuses
 Possible refunds from the government in tax disputes
 Pending court cases with a probable favorable outcome
 Tax losses carry forwards
Gain contingencies are not recorded, but disclosed only if probability of receipt is high.

Common loss contingencies:

 Litigation, claims, and assessments - Companies must consider the following factors, in determining
whether to record a liability with respect to pending or threatened litigation and actual or possible
claims and assessments.
 Time period in which the action occurred.
 Probability of an unfavorable outcome.
 Ability to make a reasonable estimate of the loss.
 Guarantee and warranty costs - Promise made by a seller to a buyer to make good on a deficiency of
quantity, quality, or performance in a product. If it is probable that customers will make warranty
claims and a company can reasonably estimate the costs involved, the company must record an
expense.
 Premiums and coupons - Companies should charge the costs of premiums and coupons to expense in
the period of the sale that benefits from the plan.
 Accounting: Company estimates the number of outstanding premium offers that customers
will present for redemption. Company charges the cost of premium offers to Premium
Expense and credits Estimated Liability for Premiums.
 Environmental liabilities - A company must recognize an asset retirement obligation when it has an
existing legal obligation associated with the retirement of a long-lived asset and when it can
reasonably estimate the amount of the liability.

Accrual of Loss Contingencies

An estimated loss or expense from a loss contingency shall be accrued by a charge to income if both of
the following conditions are met:
(a) Information available prior to issuance of the financial statements indicates that it is probable that an
asset had been impaired or a liability had been incurred at the date of financial statements. It is
implicit in this condition that it must be probable that one or more future events will occur
confirming the fact of the loss.
(b) The amount of loss can be reasonably estimated.

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When the range of loss can be reasonably estimated but no single amount within the range appears to be a
better estimate than any other amount within the range, the minimum amount in the range should be
accrued, and the amount of any additional possible loss is disclosed in a note to the financial statements.
For example, assume that on the balance sheet date Ellen Company had lost a lawsuit, but the amount of
damages remains unresolved. A reasonable estimate is that the judgment will be for not less than $2
million or more than $6 million. No amount between $2 million and $6 million appears to be a better
estimate than any other amount. The company records this loss contingency as follows:
Litigation loss 2,000,000
Liability from litigation 2,000,000
To record minimum amount of contingency loss

Summary of Statement No. 5, "Accounting for Contingencies":

Probability that Contingency can be reasonably Contingency cannot be reasonably
contingency exists estimated estimated
Loss contingencies:
a. Probable Accrued and included in financial Not accrued, but report in a note to the
statement. financial statement.

b. Reasonably Not accrued, but report in a note to the Not accrued, but report in a note to the
possible financial statement. financial statement.

c. Remote Not accrued, a note to the financial Not accrued, a note to the financial
statement is permitted but not required. statement is permitted but not required.
Gain contingencies:
a. Probable Not accrued, except in unusual Not accrued, but disclosed in a note to
situations; disclosure in a note to the the financial statements in a manner that
financial statements is required. does not give an impression realization
of gain is likely.

b. Reasonably Not accrued, but disclosed in a note to Not accrued, but disclosed in a note to
possible the financial statements in a manner that the financial statements in a manner that
does not give an impression realization does not give an impression realization
of gain is likely. of gain is likely.

c. Remote No disclosure required. No disclosure required.

Accounting for Loss Contingencies When Liability Has Been Incurred -Warranty Costs
Product warranties are presumed to give rise to a probable liability that can be estimated. When goods are
sold, an estimate of the amount of warranty costs to be incurred on the goods should be recorded as
expense, with the offsetting credit to a Warranty Liability account. As warranty work is performed, the
Warranty Liability is reduced and Cash (or other resources used) is credited. In this manner, the expense
is recorded in the same period as the sale (matching principle). Following are illustrative entries for
warranties. In reviewing these entries, note the accompanying explanations:
The warranty calculations can require consideration of beginning balances, additional accruals, and
warranty work performed. Assume ZYD Company had a beginning-of-year Warranty Liability account

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balance of $25,000. During the year ZYD sells $3,500,000 worth of goods, eventually expecting to incur
warranty costs equal to 2% of sales ($3,500,000 X 2% = $70,000). The 2% rate is an estimate based on
the best information available. Such rates vary considerably by company and product. $80,000 was
actually spent on warranty work. How much is the end-of-year Warranty Liability? The T-account reveals
an ending warranty liability of $15,000.

Liability under Product Warranty

$25,000 - beg. Bal
Actual expense $80,000 70,000 - estimated liability
$15,000 - ending bal.

Journal entries for product warranty liability recorded at the time of sale.
Product Warranty Expense 70,000
Liability under Product Warranty 70,000
To record estimate liability under Product Warranty

Liability under Product Warranty 80,000

Cash (or Accounts Payable, Inventories of Parts, etc) 80,000
To record costs of servicing customer claims

2.4. Presentation of Current Liabilities

In practice, current liabilities are usually recorded and reported in financial statements at their full
maturity value. Because of the short time periods involved, frequently less than one year, the difference
between the present value of a current liability and the maturity value is usually not large.

The current liabilities accounts are commonly presented as the first classification in the liabilities and
stockholders’ equity section of the balance sheet. Within the current liabilities section, companies may list
the accounts in order of maturity, in descending order of amount, or in order of liquidation preference.

Presentation of Contingencies – a company records a loss contingency and a liability if the loss is both
probable and estimable. But, if the loss is either probable or estimable but not both, and if there is at least
a reasonable possibility that a company may have incurred a liability, it must disclose the following in the
notes.
 The nature of the contingency.
 An estimate of the possible loss or range of loss or a statement that an estimate cannot be made.

Presented below is a financial statement that is representative of the reports of large corporations:

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Companies reporting under IFRS often report noncurrent liabilities before current liabilities.

Chapter Review Questions

1. How are current liabilities related by definition to current assets? How are current liabilities related to
a company’s operating cycle?
2. What is the nature of a “discount” on notes payable?
3. Define (a) a contingency and (b) a contingent liability.
4. Under what conditions a contingent liability should be recorded?
5. Distinguish between a current liability and a contingent liability.
6. How are the terms “probable”, “reasonably possible”, and “remote” related to contingent liabilities?

7. On September 1, Eagle Boats borrows $80,000 from Commercial Bank. The note is due in 6 months
and has a stated interest rate of 9%. Assume Eagle Boats’ year-end is December 31.
(a) Record the borrowing on September 1.
(b) How much interest is due to Commercial Bank at year-end, on December 31?
(c) Record the necessary adjustment at year-end.
(d) Record the necessary journal entry when the note matures on February 28.

2. On May 1, Batter-Up, Inc. issued a one-year, noninterest-bearing note with a face amount
of $10,600 in exchange for equipment valued at $10,000.
(a) How much interest will Batter-Up pay on the note?
(b) What is the effective interest rate on the note?

3. On October 2, 2010, a company truck was involved in an accident with a car driven by Alexander. On
January 12, 2011 the company was notified that Alexander had filed a lawsuit seeking damages for

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 personal injuries in the amount of $800,000. The company's counsel believes it is reasonably possible
that Alexander will be awarded between $250,000 and $500,000 and $400,000 is a better estimate of
potential liability than any other amount. The company's financial statements were issued on March 1,
2011. What amount of loss should the company accrue at December 31, 2010?

4. On November 1, Epic Distributors borrowed $24 million cash to fund an expansion of its facilities.
The loan was made by AIB SC under a short-term line of credit. Epic issued a 9-month, 12%
promissory note. Interest was payable at maturity. Epic's fiscal period is the Gregorian calendar year.
In Epic's adjusting entry for the note on December 31, what will be the amount of interest expense?

5. On October 1, 2011, Parton Industries borrowed $12 million cash to provide working capital. The
loan was made by Second Bank under a short-term line of credit. Parton issued an 8-month,
"noninterest-bearing note". 8% is the bank's stated "discount rate". Parton's fiscal period is the
Gregorian calendar year. In Parton's 2011 income statement interest expense for the note will be?

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