Intermediate Financial Accounting II

21/02/2023

Chapter One

Current Liabilities, Provisions, and Contingencies

1.1. Current Liabilities
The question, “What is a liability?” is not easy to answer. For example, are preference shares a
liability or an ownership claim? The first reaction is to say that preference shares are in fact an
ownership claim, and companies should report them as part of equity. In fact, preference shares
have many elements of debt as well. The issuer (and in some cases the holder) often has the right
to call the shares within a specific period of time—making it similar to a repayment of principal.
The dividends on the preference shares are in many cases almost guaranteed (the cumulative
provision)—making it look like interest. As a result, preference shares are but one of many
financial instruments that are difficult to classify.

To help resolve some of these controversies, the IASB, as part of its Conceptual Framework,
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).

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. They are
therefore in a slightly different category. This feature gives rise to the basic division of liabilities
into (1) current liabilities and (2) non-current liabilities.

Recall that current assets are cash or other assets that companies reasonably expect to convert
into cash, sell, or consume in operations within a single operating cycle or within a year (if
completing more than one cycle each year). Similarly, a current liability is reported if one of two
conditions exists:

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The liability is expected to be settled within its normal operating cycle; or

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. Industries that manufacture products
requiring an aging process as well as certain capital-intensive industries have an operating cycle
of considerably more than one year. In these cases, companies classify operating items, such as
accounts payable and accruals for wages and other expenses, as current liabilities, even if they
are due to be settled more than 12 months after the reporting period. Here are some typical
current liabilities:

1. Accounts payable. 6. Customer advances and deposits.

2. Notes payable. 7. Unearned revenues.
3. Current maturities of long-term debt. 8. Sales and value-added taxes payable.
4. Short-term obligations expected to be 9. Income taxes payable.
refinanced. 10. Employee-related liabilities.
5. Dividends payable.

1. 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. The terms of the sale
(e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30 to 60
days.

Most companies record liabilities for purchases of goods upon receipt of the goods. If title has
passed to the purchaser before receipt of the goods, the company should record the transaction at
the time of title passage. A company must pay special attention to transactions occurring near the
end of one accounting period and at the beginning of the next. It needs to ascertain that the
record of goods received (the inventory) agrees with the liability (accounts payable), and that it
records both in the proper period.

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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.

2. 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. Companies classify notes as short-term or long-term, depending on the
payment due date. Notes may also be interest-bearing or zero-interest-bearing.

 Interest-Bearing Note Issued

Assume that Castle Bank agrees to lend €100,000 on March 1, 2022, to Landscape Co. if
Landscape signs a €100,000, 6 percent, four-month note. Landscape records the cash received on
March 1 as follows.

If Landscape prepares financial statements semiannually, it makes the following adjusting entry
to recognize interest expense and interest payable of €2,000 (€100,000 × 6% × 4/12) at June 30,
2022.

If Landscape prepares financial statements monthly, its interest expense at the end of each month
is €500 (€100,000 × 6% × 1/12). At maturity (July 1, 2022), Landscape must pay the face value

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of the note (€100,000) plus €2,000 interest (€100,000 × 6% × 4/12). Landscape records payment
of the note and accrued interest as follows.

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 Landscape issues a €102,000, four-month, zero-interest-bearing note to
Castle Bank on March 1, 2022. The present value of the note is €100,000. Landscape records this
transaction as follows.

Landscape credits the Notes Payable account for the present value of the note, which is
€100,000. If Landscape prepares financial statements semiannually, it makes the following
adjusting entry to recognize the interest expense and the increase in the note payable of €2,000 at
June 30, 2022.

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At maturity (July 1, 2022), Landscape must pay the face value of the note, as follows.

3. Current Maturities of Long-Term Debt

Ahold Delhaize Group (NLD/BEL) reports as part of its current liabilities the portion of bonds,
mortgage notes, and other long-term indebtedness that matures within the next fiscal year. It
categorizes this amount as current maturities of long-term debt. Companies such as Ahold
Delhaize exclude currently maturing long-term debts from current liabilities if they are to be:
 Refinanced, or retired from the proceeds of a new long-term debt issue (discussed in the
next section); or,
 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 a company retires through a series of annual installments, a 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, if longer).
Liabilities often become callable by the creditor when there is a violation of the debt agreement.
For example, most debt agreements specify that a given level of equity to debt be maintained, or
specify that working capital be of a minimum amount. If the company violates an agreement, it
must classify the debt as current because it is a reasonable expectation that existing working
capital will be used to satisfy the debt.

To illustrate a breach of a covenant, assume that Gyro Company on November 1, 2022, has a
long-term note payable to Sanchez SA, which is due on April 1, 2024. Unfortunately, Gyro
breaches a covenant in the note, and the obligation becomes payable on demand. Gyro is
preparing its financial statements at December 31, 2022. 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, 2022, to provide a grace period for the breach of the
agreement. The grace period must end at least 12 months after December 31, 2022, to be

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reported as a non-current liability. If the agreement is not finalized by December 31, 2022, Gyro
must classify the note payable as a current liability.

4. 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 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.

5. 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. Nevertheless, companies
should disclose the amount of cumulative dividends unpaid in a note, or show it parenthetically
in the share capital section
6. 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. For example, a
company like Vodafone (GBR) often requires a deposit on equipment that customers use to
connect to the Internet or to access Vodafone’s other services. Vodafone also may receive
deposits from customers as guarantees for possible damage to property. Additionally, some

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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.
7. Unearned Revenues
A magazine publisher such as Hachette (FRA) receives payment when a customer subscribes to
its magazines. An airline company such as China Southern Airlines (CHN) sells tickets for future
flights. And software companies like Microsoft (USA) 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?
When a company receives an advance payment, it debits Cash and credits a current
liability account identifying the source of the unearned revenue.
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 $50 each for its
five game home schedules. Logo University records the sales of season tickets as follows.

After each game, Logo University makes the following entry.

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. Unearned revenue is material for some

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companies: In the airline industry, for example, tickets sold for future flights represent almost 50
percent of total current liabilities.
8. 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 €2,400. Assuming a sales tax rate of 10 percent, Halo
Supermarket makes the following entry to record the sale.

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 €240 to the tax authority.
Sometimes, the sales tax collections credited to the liability account are not equal to the liability
as computed by the governmental formula. In such a case, companies make an adjustment of the
liability account by recognizing a gain or a loss on sales tax collections. Many companies do not
segregate the sales tax and the amount of the sale at the time of sale. Instead, the company credits
both amounts in total in the Sales Revenue account. Then, to reflect correctly the actual amount
of sales and the liability for sales taxes, the company debits the Sales Revenue account for the
amount of the sales taxes due the government on these sales and credits the Sales Taxes Payable
account for the same amount.
To illustrate, assume that the Sales Revenue account balance of €150,000 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 €144,230.77
(€150,000 ÷ 1.04) and the sales tax liability is €5,769.23 (€144,230.77 × 0.04, or €150,000 −
€144,230.77). The following entry records the amount due to the tax authority.

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

Hill Farms Wheat then remits the €100 to the tax authority.
Sunshine Baking makes loaves of bread from this wheat and sells it to Halo Supermarket for
€2,000. Sunshine Baking makes the following entry to record the sale, assuming the VAT is
10 Percent

Sunshine Baking then remits €100 to the government, not €200. The reason: Sunshine Baking
has already paid €100 to Hill Farms Wheat. At this point, the tax authority is only entitled to

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€100.
Sunshine Baking receives a credit for the VAT paid to Hill Farms Wheat, which reduces the
VAT payable.
Halo Supermarket sells the loaves of bread to consumers for €2,400. Halo Supermarket
makes the following entry to record the sale, assuming the VAT is 10 percent.

Halo Supermarket then sends only €40 to the tax authority, because it deducts the €200 VAT
already paid to Sunshine Baking.
9. Income Taxes Payable
Most income tax varies in proportion to the amount of annual income. Using the best information
and advice available, a business must prepare an income tax return and compute the income
taxes payable resulting from the operations of the current period. Companies should classify as a
current liability the taxes payable on net income, as computed per the tax return. However, in
many countries proprietorships and partnerships are not taxable entities. Because the individual
proprietor and the members of a partnership are subject to personal income taxes on their share
of the business’s taxable income, income tax liabilities do not appear on the financial statements
of proprietorships and partnerships.
Most companies must make periodic tax payments throughout the year to the appropriate
government agency. These payments are based upon estimates of the total annual tax liability. As
the estimated total tax liability changes, the periodic payments also change. If, in a later year, the
taxing authority assesses an additional tax on the income of an earlier year, the company should
credit Income Taxes Payable and charge the related debit to current operations.
Differences between taxable income under the tax laws and accounting income under IFRS
sometimes occur. Because of these differences, the amount of income taxes payable to the
government in any given year may differ substantially from income tax expense as reported on
the financial statements.
10. Employee-Related Liabilities

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Companies also report as a current liability amounts owed to employees for salaries or wages at
the end of an accounting period. In addition, they often also report as current liabilities the
following items related to employee compensation.
 Payroll deductions.
 Compensated absences.
 Bonuses.
1.2. Provisions
1.2.1. Recognition of a Provision
Companies accrue an expense and related liability for a provision only if the following three
conditions are met.
 A company has a present obligation (legal or constructive) as a result of a past event;
 It is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation; and
 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 mean the probability of occurrence is greater
than 50 percent. If the probability is 50 percent or less, the provision is not recognized.
1.2.2. 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? 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:

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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 might have high remediation costs related to
environmental clean-up, may consider future technological innovations that reduce future
remediation costs.
1.2.3. Common Types of Provisions
Here are some common areas for which provisions may be recognized in the financial
statements:

1.3. Contingencies

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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.
1.3.1. 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 collectability of a receivable.
1.3.2. 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:
 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.
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.
1.4. 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 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.

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