Chapter Two

Current Liabilities and Contingencies

Liabilities
 Def. are 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.
 Recorded when obligations are incurred, and are measured at the amounts to be paid or at the
present value of these amounts.
Current liabilities versus Long – Term liabilities
 The distinction between current liabilities and long-term liabilities is important because it enables
to assess the business enterprise’s ability to settle its maturing debt.
 Current liabilities: are obligations for which payment will require
1. The use of current assets, or In one year or one operating cycle,
2. The creation of other current liabilities whichever is longer
Current liabilities include payables to suppliers and employees; accruals for taxes, rents; advance
collection from customers; obligation that are payable on demand within one year even though the
liquidation may not be expected within that period.
* Current liabilities do not include those obligation not settled within one operating cycle;
* Obligations that will be liquidated by the issuance of shares of capital stock; are included in
stockholders’ equity in the balance sheet not current liabilities.
* The relationship between current assets and current liabilities, and the relationship between
cash balance and current liabilities is important because it shows the solvency of the business
(i.e. the ability to pay debts as they mature).
Recognition and valuation of current liabilities
In theory, the measure of any liability at the time it is incurred is the present value of the required
future cash out flow. In practice, however, most current liabilities are recorded at face amount. The
difference between the present value of a current liability and the amount that will be paid at maturity
usually is not material because of the short time period involved.
The recognition of liabilities poses two conditions,
(i) Liabilities include future cash outflow that result from past transactions and events, and
(ii) Measured with reasonable accuracy.
With regard to liabilities two questions always are going to be asked
(1) Does the liability exist?
(2) If it exists, what is the amount of the obligation?
Degree of uncertainty is a major factor for the measurement of current liabilities, in this chapter we
will discussed in three basic headings;
1. Definitely measurable liabilities
2. Liabilities dependent on operating results
3. Contingencies
1. Definitely measurable liabilities
The amount of an obligation and its due date are known with reasonable certainty because they result
from contracts or the operation of statutes. Let’s give specific examples with their respective
explanations.

A. Trade Accounts Payable

Trade accounts payable resulted from purchases of goods and services on account. There are two
ways of recording trade accounts payable,

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(1) Gross Method: -
 Trade accounts payable are recorded at face amount.
 The purchases discounts ledger account is credited for discounts taken, and
 A material amount of discounts available to be taken at the end of an accounting period is accrued
by a debit to Allowance for Purchases Discounts (a contra-liability ledger account).
 The balance of the purchase discount is deducted from purchases to give net purchases.
(2) Net Method: -
 Purchase is recorded net of discounts at the time of purchases.
 For discounts not taken the Purchases Discounts Lost account is debited.
 In the income statement, the amount of Purchases Discounts Lost is reported under other
Expenses.
Exercise 1
Assume that the following information is taken from Alpha Plc. For year 6:
A) Purchases Br. 1, 000, 000 of merchandise on terms 2/10, n/30
B) Paid invoices for purchases of Br. 500, 000 within the discount period and for
purchases of Br. 200, 000 after the discount period
C) Estimated at the end of year 6 that 80% of Br. 300, 000 outstanding trade accounts
payable would be paid within the discount period.
Required-
Required- Give journal entries and balance sheet presentation related to trade accounts payable using
gross method
Solution-
Solution- (a) Purchases 1, 000,000
Trade Accounts payable 1, 000, 000
(b) Trade Accounts Payable (500, 000 + 200, 000) 700, 000
Purchased Discounts (500, 000 x 0.02) 10, 000
Cash 690, 000
(c) Allowance for Purchased Discounts (300, 000 x 0.08 x 0.02) 4, 800
Purchases Discounts 4, 800
Excerpt from balance sheet – End of year 6
Trade Accounts Payable (1, 000, 000 – 700, 000) 300, 000
Less: Allowance for purchases Discounts 4, 800
Carrying Amount 295, 200

B. Loan obligations and Refinancing of short-term Debt

Includes
 Short term promissory notes
 Any portion of long-term debt due within one year
Excludes Long-term debt currently maturing expected to be retired from;
 Sinking fund
 Proceeds of new long-term debt, or
 Through conversion to common stock
Note; short-term debt that is expected to be refinanced on a long term-term basis may be excluded
from current liabilities.
Promissory notes
 The accounting for promissory notes payable resembles that of accounting for promissory
notes receivable. In this section we concentrate on short-term promissory notes payable.
 When a promissory note bears a current fair rate of interest, its face amount is equal to its
present value at the time of issuance
 When a promissory note bears no interest or an unreasonably low rate of interest, the present
value of the note payable is less than its face amount. The discount of the note is converted to
interest expense over the term of the note.
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Exercise 2
Assume that in November 1, year 9, unity Co. uses a one-year noninterest bearing note as a
consideration for the acquisition of furniture. The face amount of the note is Br. 240, 000 and the
current fair rate of interest on the note is 12% compounded monthly (i.e. see the appropriate present
value table for 1% (12%/12 months) per period for three decimal places).
Required (i) The journal entries for the month of November and December
(ii) The presentation of the note in unity balance sheet on Dec. 31, year 9, the end of the
fiscal period
Journal Entries;
Solution (i) – Nov. 1 Furniture (240, 000 x p12% = 240, 000 x 0.887) 212, 880
Discount on Notes payable 27, 120
Notes payable 240, 000
Nov. 30 Interest Expenses (240, 000 – 27, 120 x 0.12 x 1/12) 2, 129
Discount on Notes payable 2, 129
Dec. 31 Interest Expense (240, 000 – 27, 120 + 2, 129) x 0.12 x 1/12) 2, 150
Discount on Notes payable 2, 150

(ii) Excerpt from the balance sheet

Notes payable Br. 240, 000
Less: Discount on Notes payable (27, 120 – 2129 – 2150) 22, 841
Carrying Amount of the note Br. 217, 159
C. Refinancing of Short –Term Debt
Refinancing means replacing short-term debt with either long-term debt or equity securities, or
renewing, extending, or replacing the short-term debt with other short-term debt for more than one
operating cycle from the date of the balance sheet
Accounting standard requires that a short term debt be classified as current liabilities unless;
1. the enterprise intends to refinance the debt on a long term basis
2. its ability to carry out the refinancing
Ability to refinance on long-term basis must be demonstrated either by
(a) actually issuing long-term debt or equity securities to replace short-term debt, or
(b) Entered into a contract to replace short term debt at maturity.
When a short term debt is classified as other than a current liability, the reason for such classification
should have to be disclosed in the note to the financial statements. The specific disclosures required
include the description of the refinancing contract, the terms of any new debt incurred, and the terms
of any new equity securities issued.(see page 503)
D. Cash Dividends
When board of directors declares a cash dividend, the corporation incurs a legal obligation to pay the
dividend on a specified date. Because of short-duration between cash dividend declaration and
payment, it is a current liability.
Dividends in arrears on cumulative preferred stock are declared by the board, they are not liabilities
but disclosed in the note to the financial statements.
An undistributed stock dividend is reported in the stockholders’ equity section, not as current liability
because no cash outlay is required (i.e. specifically on stock dividends to be distributed ledger
account).
E. Advance from Customers
 A liability that is created when a business enterprise receives payments in advance from its
customers
 Sometimes referred as deferred revenue or deferred credit
 The organization obligated to perform by delivery of goods or service
 When performance takes place the amount of liability diminishes and is transferred to revenue
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Examples include
o Deposits on sales order
o Magazine subscription received in advance
o Billings in excess of cost incurred on construction-type contracts
F. Accrued Liabilities
Accrued liabilities /accrued expenses are obligations that come into existence as a result of past
contractual commitments. To explain this topic, let’s discuss accrued salary and property taxes.
Accrued Salary – a liability that is related to payrolls expenses of the organizations. There are
various deductions to calculate the liability for net pay. Some of the deductions include pension
contribution, income taxes withhold, contribution for labor union, penalties, etc. Here simply to give
hypothetical journal entry.
Salaries Expenses xxx
Payroll Taxes Expenses xxx
Taxes payable xxx
Liability for income Taxes withhold xxx
Accrued payroll xxx
Property Taxes
 are sources of revenue for the government
 Based on the assessed value of real and personal property.
There are two accounting issues which arise relating to property taxes:
(1) When should the liability for property taxes be recorded?
a) On the lien date, when the legal liability for property tax arises
b) Accrual property of taxes during the fiscal year of the taxing unit.
Note; the second method is supported by the AICPA
(2) To which accounting period does the tax expense relate?
Because property taxes are expenses associated with the use of property during the fiscal year of the
taxing units, it seems reasonable to expense the property taxes during that period (instead of
expensing it all on the lien date)
Exercise 3
Bob Company’s plant assets are subject to property taxes by local taxing units. The fiscal year of the
local taxing units cover the period from July 1 to June 30. Property taxes of $72,000 are assessed on
March 15, Year 1, covering the fiscal year starting on July 1, year 1. The lien date is July 1, Year 1,
and taxes are payable with two installments of $36,000 each on December 10, Year 1, and on April
10, Year 2.
July 1, Year 1. Liability of $72,000 comes into existence on July 1, Year 1, the lien date.
Journal Entries
(No Journal Entries)
At the end of July, August, September, October, and November, Year 1, to record Monthly property
taxes expenses.
Journal Entries
Property Taxes Expense ($ 72,000 / 12) 6,000
Property Taxes Payable 6,000

December 10, Year 1. (To record payment of first installment of property tax bill.
Property Tax Payable ($ 6,000 @ 5) 30,000
Prepaid Property Taxes 6,000
Cash 36,000
December 31, Year 1(To record monthly property taxes expense)
Property Tax Payable 6,000
Prepaid Property Taxes 6,000

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At the end of January, February, and March, Year 2, to record monthly property taxes expense
Property Taxes Expense 6,000
Property Tax Payable 6,000
April 10, Year 2. (To record payment of second installment of property tax bill.
Property Tax Payable ($ 6,000 @ 3) 18,000
Prepaid Property Taxes 18,000
Cash 36,000
At end of April, May, and June, Year 2, to record monthly property taxes expense
Property Tax Expense 6,000
Prepaid Property Taxes 6,000
G. An accrued loss on a firm purchase commitment
To assure a steady supply of merchandise or material, a business enterprise may enter into a contract
for the future delivery of goods a fixed price for the ordered goods. If the contract is not subject to
cancellation, regardless of changes in the market price, if the price of the goods at the end of an
accounting period less than the contract price and the loss is recognized in the accounting records.
A sustained loss is recognized in the accounting period in which the price decline occurs, and the
value of the goods under contract is reduced as though these goods were on hand.
Entries are;
Loss on firm purchase commitment XX
Liability arising from firm purchase commitment XX
Exercise 4
Kacha manufacturing company makes an agreement with General Trading company in order to have
uninterrupted operations due to shortage of raw materials. On February 27, year 6, Kacha Company
contracted to purchase 10,000 tons of materials in year 7at a fixed price of $200 per ton. The contract
was not subject to cancellation. On December 31, year 6, the replacement cost the material was $ 180
per ton.
Journal entries;
Dec. 31 Year 6
Loss on firm purchase commitment ($200-$180)@10,000 $200,000
Liability arising from firm purchase commitment $200,000

2. Liabilities Dependent on operating Results

Certain obligations are computed, by their nature, based on operating results. At the end of the year
the operating results are known, therefore, there is no problem of determining such liabilities. The
problem arises in determining such obligation for interim reporting purposes. Obligations dependent
on operating results include bonuses, income taxes, royalties, etc.
Income Taxes
Business enterprises based on the number of owners, are classified into single proprietorship,
partnerships and corporations. The first two, namely single proprietorship and partnership, are not
taxable entities and therefore do not report income tax liabilities in their balance sheets. However,
corporation is a taxable entity and income tax liabilities appear in the balance sheet of such entities.
Corporations usually are required to make payments of their estimated tax liabilities in advance. The
remaining tax not covered by the estimated payment is payable by the due date of the income tax
return.
The journal entries for tax payment advance are;
Prepaid income taxes xxx
Cash xxx
When it expires
Income taxes expense xxx
Prepaid income taxes xxx

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The journal entries, if the income tax is accrued
Adjustment for the accrued tax
Income taxes expense xxx
Income Taxes payable xxx
At the time of paying the debt
Income taxes payable xxx
Cash xxx
Bonus and profit sharing results
Contract covering rents, royalties, or employee compensation sometimes call for conditional
payments in an amount dependent on revenue/sale or income for an accounting period. Bonus used to
describe conditional payment of this type.
For example,
 royalties payment which is 20% of sales;
 rents which is composed of a fixed Br. 2,000 a month and 1% of sales;
 employee compensation based on 10% income in excess of Br. 500,000
When a bonus plan is based on income, there is a difficulty of determining which expenses are going
to be deducted. There could be three different assumptions, applying the bonus percentage on:
(1) Income before income taxes and bonus
(2) Income after bonus but before income taxes
(3) Net income (i.e. income after bonus and income taxes)
Exercise 5
Assume that Promise Insurance share co. has a bonus plan under which employees are entitled to
share among themselves 15% of income over birr 60,000 earned by their respective branches. Income
for a given branch is Birr 180,000 before bonus and income tax. Income tax rate is 35% of pretax
income.
Required
Determine the amount of bonus if the bonus contract calls for a bonus on income in excess of Birr
60,000:
(a) Before income tax and bonus
(b) Before income tax but after bonus
(c) Net income in excess of Br 60,000.
Plan a: Bonus is based on income in excess of Birr 60,000 before deduction of bonus and the income
taxes;
Bonus = .15 (Birr 180,000 – Birr 60,000)
Bonus = Birr 18,000
Plan b: Bonus is based on income excess of Birr 60,000 after deduction of the bonus but before
deduction of taxes
Bonus = .15 (Birr 180,000 – Birr 60,000 – Bonus)
= Birr 18000 - .15 Bonus
1.15 Bonus = Birr 18,000
Bonus = Birr 15,652
Plan c: Bonus is based on net income in excess of Birr 60,000 after deduction of both the bonus and
income tax
Bonus = .15 (Birr 180,000 – Birr 60,000 – Bonus - Tax)
= Birr 18,000 – .15B – .15T) ---------------------------- (1)
Tax = .35 (Birr 180,000 – Bonus)
= Br. 63,000 - .35B---------------------------------------- (2)

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Substituting (2) in (1)
Bonus = Birr 18,000 - .15B- .15(Birr 18,000 – .35B)
Bonus = Birr 18,000 - .15B - Birr 9,450 - .0525 Bonus
= Birr 18,000 - 9,450 - .0975B
= Birr 8,550 - .0975B
1.0975 Bonus = Birr 8,550
Bonus = 7,790
Journal entry to record bonus
Bonus Expense 7,790
Bonus Payable 7,790
3. Contingencies
Contingent liabilities
Contingency is uncertainty as to possible gain (gain contingency) or loss (loss contingency) to a
business enterprise that ultimately will be resolved when a future event occurs or fails to occur. When
uncertainty surrounding a gain contingency resolved, it may result in an acquisition of an asset or the
reduction of liability. When uncertainty surrounding a lose contingency is resolved, it may result in
reduction of an asset or the incurrence of a liability.
The likelihood that the future event(s) will confirm the loss may be
 Probable - likely to occur
 Reasonably possible – more than remote but less than likely
 Remote – slight chance of occurring

The preparation of financial statements requires estimates for many business activities, and the use of
estimates does not necessarily mean that a contingency exists. As an example, computing
depreciation of plant assets is certain, what is the uncertain is the periodic amounts of depreciation
expense (these may require use of estimates). To be loss contingency, it should have to be uncertain
as to even its existence not merely its amounts. Therefore, not all uncertainties inherent in the
accounting process give rise to contingencies.

Loss Contingencies
There is uncertainty as to the existence and amounts of loss to be incurred. Examples include
1. Collectability of receivable (i.e. loss as a result of failing to collect)
2. Liabilities for product warranties
3. Risk of damage to property by fire
4. Pending or threatened litigation
5. Threat of expropriation of assets
6. Selling of receivable or other assets through recourse
To explain their accounting treatment, scrutinize the following table:

Probability that Contingency can be Contingency cannot be

contingency exists reasonably estimated reasonably estimated

(1) Probable Accrued & included in the Not accrued but reported in a note
financial statements to the financial statements
(2) Reasonably
Possible Not accrued, but reported in a Not accrued, but reported in a
note to the financial statements note to the financial statements
(3) Remote Not accrued, a note to the Not accrued, a note to the
financial statements is financial statements is permitted
permitted but not required but not required

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Accrual of loss contingencies
As can be seen and implied from the above table, a loss contingency is accrued
1. Only when it is probable that an asset has been impaired or a liability incurred
2. The amount of the loss can be reasonably estimated, and
3. It must be probable that a future event will confirm the existence of the loss
You should have to note that a mere exposure to risk does not require accrual of a loss. For
example, the possibility that injury claims will be made against a business enterprise doesn’t indicate
that an asset has been impaired or that a liability has been incurred, therefore, it is not going to be
accrued.
In some instances it is difficult to give single amount estimate for the loss contingency. Instead a
range of loss can be reasonable estimated. Within the range no single amount appears to be a better
estimate than any other amount. The minimum account in the range should be accrued, and any
additional possible loss is disclosed in the note to the financial statements.
Exercise 6
Moran has been sued for industrial espionage, and the damage sought by the plaintiff amount of
$200,000. Morgan’s outside counsel and management are of the opinion that the suit has merit and
that the amount of the damages may range from a minimum of $25,000 to a maximum of $75,000.
No amount in this range is a better estimate than any other amount.
Entry to record such transactions
Litigation loss 25,000
Liability from litigation 25,000
Loss contingencies that are not accrued
Loss contingencies that do not meet the criteria for accrual, but which are at least reasonably
possible as to their existence, are disclosed in the note to the financial statements. The disclosure
should indicate the nature of the contingency and provide an estimate of possible loss, or state that
such all estimates cannot be made. An example of such a loss contingency is a legal action whose
unfavorable outcome is reasonably possible, but a reasonable estimate of loss cannot be made.
Disclosure may not be required for a loss contingency involving law suits not yet filed, unless it
appears probable that the lawsuit will be filed and that an unfavorable outcome is reasonably possible.
For loss contingency, which are remote as to their existence, disclosure may still be permitted, but not
required. Such contingencies include guarantees of indebtedness of others and agreements to
reacquire receivables that had been sold.
Gain Contingencies
Contingencies that might result in gains are not recorded until the gains are realized or realizable.
Examples of gain contingencies include probable favorable outcome of plaintiff litigation and
potential future income tax benefits of operating loss carry forwards.

Probability that Contingency can be reasonably

contingency exists estimated Contingency cannot be reasonably estimated
(1) Probable
Not accrued, except in unusual Not accrued but disclosed in a note to the
situations; disclosure in a note to financial statements in a manner that does not
the financial statements is required give an impression gain is likely
Not accrued, but reported in a note
(2) Reasonably to the financial statements in a
Possible manner that does not give an Not accrued, but reported in a note to the
impression that realization of gain financial statements in a manner that doesn’t
is likely give an impression realization of gain is likely
(3) Remote No disclosure required No disclosure required
Accounting for Loss Contingencies When Liability Has Been Incurred

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The accrual of loss contingencies requires
 A debit to a loss or expense ledger account
 A credit to either an asset or an estimated liability account
The term estimated liability
1. Used to describe an obligation that definitely exists but is uncertain as the amount and due
date
Examples include;
a) Product warranties
Most business enterprises give warranties to replace or repair a product if it proves unsatisfactory
during some specified time period. The liabilities arise at the time of sale and may be recorded;
i. At the time of sale
ii. At the end of accounting periods
Recording it at the time of sale
Estimated liability at the time of sale
Product warranty expense xxx
Liability under product warranty xxx
Recording actual costs of servicing customer claims
Liability under product warranty xxx
Cash (or Accounts payable, inventories, etc) xxx
Recording at the end of accounting period
Estimated liability at the time of sale
No entry
Recording actual costs of servicing customer claims
Product warranty expense xxx
Cash (or Accts payable, inventories, etc) xxx
Potential claims outstanding are recorded at the end of the accounting period
Product warranty expense xxx
Liability under product warranty xxx
Exercise 7
Eve Company sold a Sony TV on credit in January year 7 for $2,400, along with a one-year warranty.
Maintenance on each TV sold during the warranty period averages $200. During year 7 Eve
Company incurred cash expenditure of $180 to service the TV.
Required:
Prepare journal entries for Eve Company to record assuming that product warranty expense at the
time of sale
1. Sale of the TV
2. warranty expense
3. Expenditure made of maintenance.
b) Gift certificates
 Sold by retail stores to provide merchandise on some later date.
 The amount of liability is equal to the amount advanced by customers.
 As redemptions are made, the liability ledger account is debited and a revenue account is credited.
Examples; coupons issued by garage and gasoline station
Tickets issued by transportation enterprise
 The organization may offer obligations;
o Expired after stated period, estimating the amount of forfeits claims is simple.
o Indefinite duration – necessary to estimate potential claims that will not be redeemed and
transfer from liability ledger to a revenue account.
c) Service contracts

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Household appliances like refrigerator, TV, etc. are sold with their associated servicing contracts for a
specified period of time. The amounts received for such service contracts constitute unearned revenue
that will be earned by performance over the term of the contract. The actual costs of servicing will be
recognized as expenses.
Exercise 8
Millennium enterprise sells television service contracts for $250 each, agreeing to service customers’
sets for one year. In January year 5, 2000 such service contracts are sold. The past experience shows
that 35% of the calls tend to be made in the first month, 15% in the second month, and 5% each of the
10 subsequent months. In January and February millennium enterprise service contract cost incurred
$95,000 and 32,500 respectively.
Required:
1. Journalize sale of service contracts
2. Journalize revenue realized and cost incurred in January and February year 5.

d) Coupons and trading stamps

Coupons – for promotional purposes, coupon is issued which is exchangeable for prizes such as cash
or merchandise. The liability for the issuer is the cost of the prizes that are expected to be claimed by
customers.
Exercise 9
In year 1 Melat Company issued coupons that may be redeemed for prizes costing $5,000 if all the
coupons are presented for redemption. The past experience indicates that only 75% of the coupons
issued are presented for redemption. The company purchased $5,600 prize merchandise to be given
to customers in year 1.The Lena Company’s customers coupons during year 1 in exchange of prize
merchandise costing $3,000.
Required
1. Journalize purchase of prizes
2. Journalize redemption of coupons for prizes
3. Journalize adjusting entry to record the liability
e) Operating reserves
 Debit an expense ledger account and credit an operating reserve for costs
 Used for repairs or maintenance that has not yet been incurred.
 Estimated future payments for deferred compensation, restoration of leased properties, plant
closing and relocation costs and disposal of an industry segment sometimes are reported as
current liabilities
Disclosure of contingencies not accrued
If a loss does not the two criteria for accrual the likely of the loss is reasonably possible or remote, the
loss contingency is disclosed in a note to the financial statements.
Examples include:
Guarantee of indebtedness of others
Pending or threatened litigation
Actual or possible claims and assessments
Presentation of liabilities in balance sheet
 Current liabilities may be reported in the order of maturity or
according to amounts (largest to smallest).

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