Chapter One: Current Liabilities, Provisions and Contingencies

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1. Describe the nature, valuation, and reporting of current liabilities.
2. Explain the accounting for different types of provisions.
3. Explain the accounting for loss and gain contingencies.
4. Indicate how to present and analyze liability-related information.
In this chapter, we explain the basic issues related to accounting and reporting
for current liabilities, provisions, and contingencies.

A. Current Liabilities
The IASB defines a liability as a present obligation of a company arising from past
events, the settlement of which is expected to result in an outflow from the company of
resources, embodying economic benefits.
In other words, a liability has three essential characteristics:
1. It is a present obligation.
2. It arises from past events.
3. It results in an outflow of resources (cash, goods, services).
A current liability 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.

This definition has gained wide acceptance because it recognizes operating cycles of
varying lengths in different industries.
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:
1. Accounts payable. 5. Dividends payable.
2. Notes payable. 6. Customer advances and deposits.
3. Current maturities of long-term debt. 7. Unearned revenues.
4. Short-term obligations expected to be 8. Sales and value-added taxes payable.
refinanced. 9. Income taxes payable.
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 i. Accounts Payable
Accounts payable, or trade accounts payable, are balances owed to others for goods,
supplies, or services purchased on open account. Accounts payable arise because of
the time lag between the receipt of services or acquisition of title to assets and the
payment for them. Account payable should be recognized (recorded) up on the passage
of titles to goods purchased.
Measuring the amount of an account payable poses no particular difficulty. The
invoice received from the creditor specifies the due date and the exact outlay in money
that is necessary to settle the account. The only calculation that may be necessary
concerns the amount of cash discount.

ii. Notes Payable

Notes payable are written promises to pay a certain sum of money on a specified
future date. They may arise from purchases, financing, or other transactions. Some
industries require notes (often referred to as trade notes payable) as part of the
sales/purchases transaction in lieu of the normal extension of open account credit.
Notes payable to banks or loan companies generally arise from cash loans. Notes may
be interest-bearing or zero-interest-bearing.
Interest-Bearing Note Issued
Assume that Abyssinia Bank agrees to lend Br100,000 on March 1, 2019, to ABC Co.
if ABC signs a Br100,000, 6 percent, four-month note. Present journal entries to ABC.

March 1, 2019
Cash 100,00
0
Notes Payable 100,000
(To record issuance of 6%, 4-month note to Abyssinia Bank)
If ABC prepares financial statements semiannually, it makes the following adjusting
entry to recognize interest expense and interest payable of Br2,000 (Br100,000 × 6% ×
4/12) at June 30, 2019.

June 30, 2019

Interest Expense 2,000
Interest Payable 2,000
(To accrue interest for 4 months on Abyssinia Bank)
If ABC prepares financial statements monthly, its interest expense at the end of each
month is Br500 (Br100,000 × 6% × 1/12).
At maturity (July 1, 2019), ABC must pay the face value of the note (Br100,000) plus
Br2,000 interest (Br100,000 × 6% × 4/12). ABC records payment of the note and
accrued interest as follows.

July 1, 2019
Notes Payable 100,00
0
Interest Payable 2,000
Cash 102,000
(To record payment of Abyssinia Bank interest bearing note and accrued
interest at maturity.

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Zero-Interest-Bearing Note Issued
A company may issue a zero-interest-bearing note instead of an interest-bearing note.
A zero interest-bearing note does not explicitly state an interest rate on the face of the
note. Interest is still charged, however. At maturity, the borrower must pay back an
amount greater than the cash received at the issuance date. In other words, the
borrower receives in cash the present value of the note. The present value equals the
face value of the note at maturity minus the interest or discount charged by the lender
for the term of the note.
To illustrate, assume that ABC issues a Br102,000, four-month, zero-interest-bearing
note to Abyssinia Bank on March 1, 2019. The present value of the note is Br100,000.
ABC records this transaction as follows.

March 1, 2019
Cash 100,00
0
Notes Payable 100,000
(To record issuance of 4-month, zero interest bearing note to Abyssinia
Bank)
ABC credits the Notes Payable account for the present value of the note, which is
Br100,000. If ABC prepares financial statements semiannually, it makes the following
adjusting entry to recognize the interest expense and the increase in the note payable
of Br2,000 at June 30, 2019.

June 30, 2019

Interest Expense 2,000
Notes Payable 2,000
(To accrue interest for 4 months on Abyssinia Bank)
At maturity (July 1, 2019), ABC must pay the face value of the note, as follows.

July 1, 2019
Notes Payable 102,00
0
Cash 102,000
(To record payment of Abyssinia Bank zero-interest bearing note at
maturity.
E2-2: (Accounts and Notes Payable) the following are selected 2010 transactions of
Darby Corporation.
Sept. 1 - Purchased inventory from Orion Company on account for Br50,000. Darby
records purchases gross and uses a periodic inventory system.
Oct. 1 - Issued a Br50,000, 12-month, 8% note to Orion in payment of account.
Oct. 1 - Borrowed Br75,000 from the Shore Bank by signing a 12-month, zero-
interest-bearing Br81,000 note.
Prepare journal entries for the selected transactions.
Solution:
Date Description Debit Credit
Sept 1 Purchases 50,000
Account Payable 50,000
(To record purchase of inventory on account)
Oct 1 Accounts payable 50,000
Notes Payable 50,000
(Issuance of 8%, 12month note)

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 Dec 31 Interest Expense 1,000
Interest Payable 1,000
Interest accrued at year end(50,000x8%x3/12= 1,000)

Ex-3: Oct. 1 - Borrowed Br75,000 from the Shore Bank by signing a 12-month, zero-
interest-bearing Br81,000 note.
Oct. 1Cash 75,000
Notes payable 75,000

Dec. 31 Interest expense 1,500

Notes payable 1,500
iii. Current Maturities of Long-Term Debt
The portion of bonds, mortgage notes, and other long-term obligation that matures
within the next fiscal year or within 12 months after the reporting date.
Excludes currently maturing long-term debts from current liabilities if they are to be:
1. Retired by assets accumulated for this purpose that properly have not been
shown as current assets;
2. Refinanced, or retired from the proceeds of a new long-term debt issue; or
3. Converted into ordinary shares.
When only a part of a long-term debt is to be paid within the next 12 months, as in
the case of serial bonds that it 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.
However, a company should classify as current any liability that is due on demand
(callable by the creditor) or will be due on demand within one year (or operating cycle).
Liabilities often become callable by the creditor when there is a violation of the debt
agreement.
To illustrate a breach of a covenant, assume that Gyro Company on November 1,
2015, has a long-term note payable to Sanchez SA, which is due on April 1, 2021.
Unfortunately, Gyro breaches a covenant in the note, and the obligation becomes
payable on demand. Gyro is preparing its financial statements at December 31, 2019.
Given the breach in the covenant, Gyro must classify its obligation as current.
However, Gyro can classify the liability as non-current if
Sanchez agrees before December 31, 2019, to provide a grace period for the breach of
the agreement. The grace period must end at least 12 months after December 31,
2019, to be reported as a non-current liability. If the agreement is not finalized by
December 31, 2019, Gyro must classify the note payable as a current liability.
Short-Term Obligations Expected to Be Refinanced
Short-term obligations are debts scheduled to mature within one year after the date of
a company's statement of financial position or within its normal operating cycle. Some
short-term obligations short-term obligations expected to be refinanced are expected to
be refinanced on a long-term basis. These short-term obligations will not require the
use of working capital during the next year (or operating cycle).
At one time, the accounting profession generally supported the exclusion of short-term
obligations from current liabilities if they were “expected to be refinanced. “ But the
profession provided no specific guidelines, so companies determined whether a short-
term obligation was “expected to be refinanced” based solely on management's intent
to refinance on a long term basis. Classification was not clear-cut. For example, a
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company might obtain a five-year bank loan but handle the actual financing with 90-
day notes, which it must keep turning over (renewing). In this case, is the loan a long-
term debt or a current liability? It depends on refinancing criteria.
Refinancing Criteria
To resolve these classification problems, the IASB has developed criteria for
determining the circumstances under which short-term obligations may be properly
excluded from current liabilities. 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.
Intention to refinance on a long-term basis means that the company intends to
refinance the short-term obligation so that it will not require the use of working capital
during the ensuing fiscal year (or operating cycle, if longer). Entering into a financing
arrangement that clearly permits the company to refinance the debt on a long-term
basis on terms that are readily determinable before the next reporting date is one way
to satisfy the second condition. In addition, the fact that a company has the right to
refinance at any time and intends to do so permits the company to classify the liability
as non-current.
To illustrate, assume that Haddad SE provides the following information related to its
note payable.

 Issued note payable of Br3,000,000 on November 30, 2019, due on February

28, 2020. Haddad's reporting date is December 31, 2019.
 Haddad intends to extend the maturity date of the loan (refinance the loan) to
June 30, 2021
 Its December 31, 2019, financial statements are authorized for issue on March
15, 2020.
 The necessary paperwork to refinance the loan is completed on January 15,
2020. Haddad did not have an unconditional right to defer settlement of the
obligation at December 31, 2019.
A graphical representation of the refinancing events is:

Refinancing Events
In this case, Haddad must classify its note payable as a current liability because
the refinancing was not completed by December 31, 2019, the financial reporting
date. Only if the refinancing was completed before December 31, 2019, can
Haddad classify the note obligation as noncurrent. The rationale: Refinancing a
liability after the statement of financial position date does not affect the liquidity
or solvency at the date of the statement of financial position, the reporting of
which should reflect contractual agreements in force on that date.
What happens if Haddad has both the intention and the discretion (within the
loan agreement) to refinance or roll over its Br3,000,000 note payable to June 30,
//Intermediate Financial Accounting II//5
2021? In this case, Haddad should classify the note payable as non-current
because it has the ability to defer the payment to June 30, 2021.
iv. Dividends Payable
A cash dividend payable is an amount owed by a company to its shareholders as a
result of the board of directors' authorization (or in other cases, vote of
shareholders). At the date of declaration, the company assumes a liability that
places the shareholders in the position of creditors in the amount of dividends
declared. Because companies always pay cash dividends within one year of
declaration (generally within three months), 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.
Such share dividends do not require future outlays of assets or services.
Companies generally report such undistributed share dividends in the equity
section because they represent retained earnings in the process of transfer to
share capital.
v. Customer Advances and Deposits
Current liabilities may include returnable cash deposits received from customers
and employees. Companies may receive deposits from customers to guarantee
performance of a contract or service or as guarantees to cover payment of expected
future obligations. Additionally, some companies require their employees to make
deposits for the return of keys or other company property.
The classification of these items as current or non-current liabilities depends on
the time between the date of the deposit and the termination of the relationship
that required the deposit.
vi. Unearned Revenues
An airline company sells tickets for future flights. And software companies issue
coupons that allow customers to upgrade to the next version of their software.
How do these companies account for unearned revenues that they receive before
providing goods or performing services?

1. When a company receives an advance payment, it debits Cash and credits a

current liability account identifying the source of the unearned revenue.
2. When a company recognizes revenue, it debits the unearned revenue account
and credits a revenue account.
To illustrate, assume that Logo University sells 10,000 season soccer tickets at
Br50 each for its five-game home schedule. Logo University records the sales of
season tickets as follows.

After each game, Logo University makes the following entry.

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The account Unearned Sales Revenue represents unearned revenue. Logo
University reports it as a current liability in the statement of financial position
because the school has a performance obligation. As ticket holders attend games,
Logo recognizes revenue and reclassifies the amount from Unearned Sales
Revenue to Sales Revenue.
Illustration 13.2 shows specific unearned revenue and revenue accounts
sometimes used in selected types of businesses.

ILLUSTRATION 13.2 Unearned Revenue and Revenue Accounts

The statement of financial position reports obligations (liabilities) for any

commitments that are redeemable in goods and services. The income statement
reports revenues related to performance obligations satisfied during the period.
vii. 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 similar to the company or personal income tax. These
two taxes accomplish the same objective—to tax the final consumer of the good or
service. However, the two systems use different methods to accomplish this
objective.
Sales Taxes Payable
To illustrate the accounting for sales taxes, assume that Halo Supermarket sells
loaves of bread to consumers on a given day for Br2,400. Assuming a sales tax
rate of 10 percent, Halo Supermarket makes the following entry to record the sale.

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In this situation, Halo Supermarket records a liability to provide for taxes collected
from customers but not yet remitted to the appropriate tax authority. At the
proper time, Halo Supermarket remits the Br240 to the tax authority.
To illustrate, assume that the Sales Revenue account balance of Br150,000
includes sales taxes of 4 percent. Thus, the amount recorded in the Sales Revenue
account is comprised of the sales amount plus sales tax of 4 percent of the sales
amount. Sales therefore are Br144,230.77 (Br150,000 ÷ 1.04) and the sales tax
liability is Br5,769.23 (Br144,230.77 × 0.04 or Br150,000 − Br144,230.77). The
following entry records the amount due to the tax authority.
Value-Added Taxes Payable
Value-added taxes (VAT) are used by tax authorities more than sales taxes (over
100 countries require that companies collect a value-added tax). As indicted
earlier, a value-added tax is a consumption tax. This tax is placed on a product or
service whenever value is added at a stage of production and at final sale. A VAT is
a cost to the end user, normally a private individual,
similar to a sales tax. However, a VAT should not be confused with a sales tax. A
sales tax 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. In a VAT
taxation system, the VAT is collected every time a business
purchases products from another business in the product's supply chain.
To illustrate, let's return to the Halo Supermarket example but now assume that a
VAT is imposed rather than a sales tax. To understand how a VAT works, we need
to understand how the loaves of bread were made ready for purchase. Here is
what happened.

1. Hill Farms Wheat Company grows wheat and sells it to Sunshine Baking for
Br1,000. Hill Farms Wheat makes the following entry to record the sale,
assuming the VAT is 10 percent.

Hill Farms Wheat then remits the Br100 to the tax authority.

2. Sunshine Baking makes loaves of bread from this wheat and sells it to Halo
Supermarket for Br2,000. Sunshine Baking makes the following entry to
record the sale, assuming the VAT is 10 percent.

Sunshine Baking then remits Br100 to the government, not Br200. The reason:
Sunshine Baking has already paid Br100 to Hill Farms Wheat. At this point, the
tax authority is only entitled to Br100. 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 Br2,400. Halo
Supermarket makes the following entry to record the sale, assuming the VAT is
10 percent.

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Halo Supermarket then sends only Br40 to the tax authority as it deducts the Br200
VAT already paid to Sunshine Baking. Who then in this supply chain ultimately pays
the VAT of Br240? The consumers.
Who Pays the VAT?

1. Hill Farms Wheat collected Br100 of VAT and remitted this amount to the tax
authority; it did not have a net cash outlay for these taxes.
2. Sunshine Baking collected Br200 of VAT but only remitted Br100 to the tax
authority because it received credit for the Br100 VAT that it paid to Hill Farms
Wheat; it did not have a net cash outlay for these taxes.
3. Halo Supermarket collected Br240 of VAT but only remitted Br40 to the tax
authority because it received credit for the Br200 of VAT it paid to Sunshine
Baking; it did not have a net cash outlay for these taxes.

B. Provisions: A provision is a liability of uncertain timing or amount (sometimes

referred to as an estimated liability).
Provisions are very common and may be reported either as current or non-current
depending on the date of expected payment. Common types of provisions are
obligations related to litigation, warrantees or product guarantees, business
restructurings, and environmental damage.
The difference between a provision and other liabilities (such as accounts or notes
payable, salaries payable, and dividends payable) is that a 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 first condition, the past event (often referred to as the past
obligatory event) must have occurred. In applying the second condition, the term
probable is defined as “more likely than not to occur.” This phrase is interpreted to
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 mean the probability of occurrence is greater than 50 percent. If the probability is
50 percent or less, the provision is not recognized.
Recognition Examples
It is assumed for each of these examples that a reliable estimate of the amount of
the obligation can be determined.
a. WARRANTY
Facts: Santos SA gives warranties to its customers related to the sale of its
electrical products. The warranties are for three years from the date of sale.
Based on past experience, it is probable (more likely than not) that there will
be some claims under the warranties.
Question: Should Santos recognize at the statement of financial position date a
provision for the warranty costs yet to be settled?
Solution: (1) The warranty is a present obligation as a result of a past obligating
event—the past obligating event is the sale of the product with a warranty, which
gives rise to a legal obligation. (2) The warranty results in the outflow of resources
embodying benefits in settlement—it is probable that there will be some claims
related to these warranties. Santos Company should recognize the provision based
on past experience.
A constructive obligation is an obligation that derives from a company's actions
where:

1. By an established pattern of past practice, published policies, or a sufficiently

specific current statement, the company has indicated to other parties that it
will accept certain responsibilities; and
2. As a result, the company has created a valid expectation on the part of those
other parties that it will discharge those responsibilities.
Recognition of a Provision—Refunds
REFUNDS
Facts: Christian Dior (FRA) has a policy of refunding purchases to dissatisfied
customers even though it is under no legal obligation to do so. Its policy of making
refunds is generally known.
Question: Should Christian Dior record a provision for these refunds?
Solution: (1) The refunds are a present obligation as a result of a past obligating event
—the sale of the product. This sale gives rise to a constructive obligation because the
conduct of the company has created a valid expectation on the part of its customers
that it will refund purchases. (2) The refunds result in the outflow of resources in
settlement—it is probable that a proportion of goods are returned for refund. A
provision is recognized for the best estimate of the costs of refunds.
Recognition of a Provision—Lawsuit
LAWSUIT
Facts: Assume that an employee filed a £1,000,000 lawsuit on November 30, 2019,
against Wm Morrison Supermarkets for damages suffered when the employee slipped
and suffered a serious injury at one of the company's facilities. Morrison's lawyers
believe that Morrison will not lose the lawsuit, putting the probability of future
payments at less than 50 percent.
Question: Should Morrison recognize a provision for legal claims at December 31,
2019?

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Solution: Although a past obligating event has occurred (the injury leading to the
filing of the lawsuit), it is not probable (more likely than not) that Morrison will have to
pay any damages. Morrison therefore does not need to record a provision. If, on the
other hand, Morrison's lawyer determined that it is probable that the company will
lose the lawsuit, then Morrison should recognize a provision at December 31, 201 9.
Measurement of Provisions
How does a company like Toyota (JPN), for example, determine the amount to report
for its warranty cost on its automobiles? How does a company like Carrefour (FRA)
determine its liability for customer refunds? Or, how does Novartis (CHE) determine
the amount to report for a lawsuit that it probably will lose? And, how does a company
like Total SA (FRA) determine the amount to report as a provision for its remediation
costs related to environmental clean-up?
IFRS provides an answer: 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 is how this judgment might be used in three different
types of situations to arrive at best estimate:
 Toyota warranties. Toyota sells many cars and must make an estimate of the
number of warranty repairs and related costs it will incur. Because it is dealing
with a large population of automobiles, it is often best to weight all possible
outcomes by associated probabilities. For example, it might determine that 80
percent of its cars will not have any warranty cost, 12 percent will have
substantial costs, and 8 percent will have a much smaller cost. In this case, by
weighting all the possible outcomes by their associated probabilities, Toyota
arrives at an expected value for its warranty liability.
 Carrefour refunds. Carrefour sells many items at varying selling prices. Refunds
to customers for products sold may be viewed as a continuous range of refunds,
with each point in the range having the same probability of occurrence. In this
case, the midpoint in the range can be used as the basis for measuring the
amount of the refunds.
 Novartis lawsuit. Large companies like Novartis are involved in numerous
litigation issues related to their products. Where a single obligation such as a
lawsuit is being measured, the most likely outcome of the lawsuit may be the
best estimate of the liability.
In each of these situations, the measurement of the liability should consider the time
value of money, if material. In addition, future events that may have an impact on the
measurement of the costs should be considered. For example, a company like Total
SA, which may have high remediation costs related to environmental clean-up, may
consider future technological innovations that reduce future costs if reasonably
certain of happening.
Common Types of Provisions
Here are some common areas for which provisions may be recognized in the financial
statements:
1. Lawsuits
2. Warranties
3. Consideration payable
4. Environmental
5. Onerous contracts
6. Restructuring
Although companies generally report only one current and one non-current amount
for provision in the statement of financial position, IFRS also requires extensive
disclosure related to provisions in the notes to the financial statements. Companies do
not record or report in the notes to the financial statements general risk contingencies
//Intermediate Financial Accounting II//11
inherent in business operations (e.g.,
the possibility of war, strike, uninsurable catastrophes, or a business recession).
Litigation Provisions
Companies must consider the following factors, among others, in determining whether
to record a liability with respect to pending or threatened litigation, claims, and
assessments and actual or possible claims and assessments.
1. The time period in which the underlying cause of action occurred.
2. The probability of an unfavorable outcome.
3. The ability to make a reasonable estimate of the amount of loss.
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 statements. It does not matter that
the company became aware of the existence or possibility of the lawsuit or claims after
the date of the financial statements but before issuing them. To evaluate the
probability of an unfavorable outcome, a company considers the following: the nature
of the litigation, the progress of the case, the opinion of legal counsel, its own and
others' experience in similar cases, and any
management response to the lawsuit.
With respect to unfiled suits and unasserted claims and assessments, a company
must determine
1. the degree of probability that a suit may be filed or a claim or assessment
may be asserted, and
2. The probability of an unfavorable outcome.
If both are probable, if the loss is reasonably estimable, and if the cause for action is
dated on or before the date of the financial statements, then the company should
accrue the liability.
BE2-10: Scorcese Inc. is involved in a lawsuit at December 31, 2010. (a) Prepare the
December 31 entry assuming it is probable that Scorcese will be liable for Br900,000
as a result of this suit. (b) Prepare the December 31 entry, if any, assuming it is not
probable that Scorcese will be liable for any payment as a result of this suit.
(a) Lawsuit loss 900,000
Lawsuit liability 900,000
(b) No entry is necessary. The loss is not accrued because it is not probable that a
liability has been incurred at 12/31/10.
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. For a specified period
of time following the date of sale to the consumer, the manufacturer may promise to
bear all or part of the cost of replacing defective parts, to perform any necessary
repairs or servicing without charge, to refund the purchase price, or even to “double
your money back.”
Companies often provide one of two types of warranties to customers:
1. Warranty that the product meets agreed-upon specifications in the contract at
the time the product is sold. This type of warranty is included in the sales price
of a company's product and is often referred to as an assurance-type warranty.
2. Warranty that provides an additional service beyond the assurance-type
warranty. This warranty is not included in the sales price of the product and is
referred to as a service-type warranty. As a result, it is recorded as a separate
performance obligation
ASSURANCE-TYPE WARRANTY

//Intermediate Financial Accounting II//12

Exercise: Denson Machinery Company begins production of a new machine in July
2019 and sells 100 of these machines for Br5,000 cash by year-end for a total sales
revenue of Br500,000 (100 × Br5,000). Each machine is under warranty for 1 year.
Denson estimates, based on past experience with similar machines, that the warranty
cost will average Br200 per unit for a total expected warranty expense of Br20,000
(100 × Br200). Further, as a result of parts replacements and services performed in
compliance with machinery warranties, it incurs Br4,000 in warranty costs in 2019
and Br16,000 in 2020.
Question: What are the journal entries for the sale and the related warranty costs for
2019 and 2020?
Solution: For the sale of the machines and related warranty costs in 2019, the entries
are as follows.

1. To recognize sales of machines:

2. To record payment warranty costs incurred in 2019:

3. The adjusting entry to record estimated warranty expense and warranty liability
for expected warranty claims in 2020:

As a consequence of this adjusting entry at December 31, 2019, the statement of

financial position reports a warranty liability (current) of Br16,000 (Br20,000 −
Br4,000). The income statement for 2019 reports sales revenue of Br500,000 and
warranty expense of Br20,000.

4. To record payment for warranty costs incurred in 2020 related to 2019

machinery sales:

At the end of 2020, no warranty liability is reported for the machinery sold in 2019.
Service-Type Warranty.

//Intermediate Financial Accounting II//13

A warranty is sometimes sold separately from the product. For example, when you
purchase a television, you are entitled to an assurance-type warranty. You also will
undoubtedly be offered an extended warranty on the product at an additional cost,
referred to as a service-type warranty.
In most cases, service-type warranties provide the customer a service beyond fixing
defects that existed at the time of sale.
Companies record a service-type warranty as a separate performance obligation. For
example, in the case of the television, the seller recognizes the sale of the television
with the assurance type warranty separately from the sale of the service-type
warranty. The sale of the service-type warranty is usually recorded in an Unearned
Warranty Revenue account.
Companies then recognize revenue on a straight-line basis over the period the service-
type warranty is in effect. Companies only defer and amortize costs that vary with and
are directly related to the sale of the contracts (mainly commissions). Companies
expense employees' salaries and wages, advertising, and general and administrative
expenses because these costs occur even if the company did not sell the service-type
warranty.
Assurance-Type and Service-Type Warranties
WARRANTIES
Facts: You purchase an automobile from Hamlin Auto for Br30,000 on January 2,
2019. Hamlin estimates the assurance-type warranty costs on the automobile to be
Br700 (Hamlin will pay for repairs for the first 36,000 kilometers or 3 years, whichever
comes first). You also purchase for Br900 a service-type warranty for an additional 3
years or 36,000 kilometers. Hamlin incurs warranty costs related to the assurance-
type warranty of Br500 in 2019 and Br100 in 2020 and 2021. Hamlin records revenue
on the service-type warranty on a straight-line basis.
Question: What entries should Hamlin make in 2019 and 2022?
Solution:

1. To record the sale of the automobile and related warranties:

2. To record warranty costs incurred in 2019:

3. The adjusting entry to record estimated warranty expense and warranty liability
for expected assurance warranty claims in 2020:

//Intermediate Financial Accounting II//14

 As a consequence of this adjusting entry at December 31, 2019, the statement
of financial position reports a warranty liability of Br200 (Br700 − Br500) for
the assurance-type warranty. The income statement for 2019 reports sales
revenue of Br30,000 and warranty expense of Br700.

4. To record revenue recognized in 2022 on the service-type warranty:

Warranty costs under the service-type warranty will be expensed as incurred in 2022–
2024.
Consideration Payable
Companies often make payments (provide consideration) to their customers as part of
a revenue arrangement. Consideration paid or payable may include discounts, volume
rebates, free products, or services. For example, numerous companies offer premiums
(either on a limited or continuing basis) to customers in return for box tops,
certificates, coupons, labels, or wrappers.
The premium may be silverware, dishes, a small appliance, a toy, or free
transportation. Also, coupons that can be redeemed for a cash discount on items
purchased are extremely popular (see Underlying Concepts). Another popular
marketing innovation is the cash rebate, which the buyer can obtain by returning the
store receipt and a rebate coupon to the manufacturer.

Companies offer premiums, coupon offers, and rebates to stimulate sales. And to the
extent that the premiums reflect a material right promised to the customer, a
performance obligation exists and should be recorded as a liability. However, the
period that benefits is not necessarily the period in which the company pays the
premium. At the end of the accounting period, many premium offers may be
outstanding and must be redeemed when presented in subsequent periods. In order to
reflect the existing current liability, the company estimates the number of outstanding
premium offers that customers will present for redemption.
Accounting for Consideration Payable
CONSIDERATION PAYABLE
Facts: Fluffy Cake Mix Ltd. sells boxes of cake mix for £3 per box. In addition, Fluffy
Cake Mix offers its customers a large durable mixing bowl in exchange for £1 and 10
box tops. The mixing bowl costs Fluffy Cake Mix £2, and the company estimates that
customers will redeem 60 percent of the box tops. The premium offer began in June
2019. During 2019, Fluffy Cake Mix purchased 20,000 mixing bowls at £2, sold

//Intermediate Financial Accounting II//15

300,000 boxes of cake mix for £3 per box, and
redeemed 60,000 box tops.
Question: What entries should Fluffy Cake Mix record in 2019?
Solution:
1. To record purchase of 20,000 mixing bowls at £2 per bowl in 2019:
Premium Inventory (20,000 mixing bowls × £2) 40,000
Cash 40,000
2. The entry to record the sale of the cake mix boxes in 2019 is as follows:
Cash (300,000 boxes of cake mix × £3) 900,000
Sales Revenue 900,000
3. To record the actual redemption of 60,000 box tops, the receipt of £1 per 10 box
tops, and the delivery of the mixing bowls:
Cash [(60,000 ÷ 10) × £1] 6,000
Premium Expense 6,000
Inventory of Premiums [(60,000 ÷ 10) × £2] 12,000
4. The adjusting entry to record additional premium expense and the estimated
premium liability at December 31, 2019, is as follows:
Premium Expense 12,000
Premium Liability 12,000*
* Computation of Premium Liability at 12/31/19:

The December 31, 2019, statement of financial position of Fluffy Cake Mix reports
Premium inventory of £28,000 (£40,000 − £12,000) as a current asset and Premium
Liability of £12,000 (£18,000 − £6,000) as a current liability. The 2019 income
statement reports £18,000 (£6,000 + £12,000) premium expense as a selling expense.
Onerous Contract Provisions
These contracts are ones in which “the unavoidable costs of meeting the obligations
exceed the economic benefits expected to be received.” An example of an onerous
contract is a loss recognized on unfavorable non-cancelable purchase commitments
related to inventory items.
To illustrate another situation, 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 Br200,000. In this case, Sumart makes the following entry.

Loss on Lease Contract 200,000

//Intermediate Financial Accounting II//16

 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 Br200,000. However, Sumart can cancel the
lease by paying a penalty of Br175,000. In this case, Sumart should record the liability
at Br175,000.

Contingencies
In a general sense, all provisions are contingent because they are uncertain in timing
or amount. However, IFRS uses the term “contingent” for liabilities and assets that are
not recognized in the financial statements.
Contingent Liabilities
Contingent liabilities are not recognized in the financial statements because they are
(1) a possible obligation (not yet confirmed as a present obligation), (2) a present
obligation for which it is not probable that payment will be made, or (3) a present
obligation for which a reliable estimate of the obligation cannot be made. Examples of
contingent liabilities are:

 A lawsuit in which it is only possible that the company might lose.

 A guarantee related to collectibility of a receivable.
Contingent Liability Guidelines

* In practice, the percentages for virtually certain and remote may deviate from those
presented here.
Unless the possibility of any outflow in settlement is remote, companies should
disclose the contingent liability at the end of the reporting period, providing a brief
description of the nature of the contingent liability and, where practicable:

1. An estimate of its financial effect;

2. An indication of the uncertainties relating to the amount or timing of any
outflow; and
3. The possibility of any reimbursement.
Contingent Assets
A contingent asset is a possible asset that arises from past events and whose
existence will be confirmed by the occurrence or non-occurrence of uncertain future
events not wholly within the control of the company. Typical contingent assets are:
1. Possible receipts of monies from gifts, donations, and bonuses.
2. Possible refunds from the government in tax disputes.
//Intermediate Financial Accounting II//17
 3. Pending court cases with a probable favorable outcome.
Contingent assets are not recognized on the statement of financial position. If
realization of the contingent asset is virtually certain, it is no longer considered a
contingent asset and is recognized as an asset. Virtually certain is generally
interpreted to be at least a probability of 90 percent or more.
Contingent Asset Guidelines

* In practice, the percentages for virtually certain and remote may deviate from those
presented here.
Contingent assets are disclosed when an inflow of economic benefits is considered
more likely than not to occur (greater than 50 percent). However, it is important that
disclosures for contingent assets avoid giving misleading indications of the likelihood
of income arising. As a result, it is not surprising that the thresholds for allowing
recognition of contingent assets are more stringent relative to those for liabilities.

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 profession accepts as
immaterial any slight overstatement of liabilities that results from carrying current
liabilities at maturity value.
The current liabilities accounts are commonly presented after non-current liabilities in
the statement of financial position. 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.

//Intermediate Financial Accounting II//18