CHAPTER ONE: CURRENT LIABILITIES AND CONTINGENCIES

In this chapter, we explain the basic issues related to accounting and reporting for current and
contingent liabilities. The content and organization of the chapter are liabilities, current liabilities,
contingencies and presentation of current liabilities and contingencies
Definition
The FASB, as part of its conceptual framework, defined liabilities as “probable future sacrifices
of economic benefits arising from present obligations of a particular entity to transfer assets or
provide services to other entities in the future as a result of past transactions or events.”
The word obligations refer to duties imposed legally or socially which one is bound to do by
contract, promise, or moral responsibility.
In other words, a liability has three essential characteristics:
1. It is a present obligation that entails settlement by probable future transfer or use of cash,
goods, or services.
2. It is an unavoidable obligation.
3. The transaction or other event creating the obligation has already occurred.
WHAT IS A CURRENT LIABILITY?
Current liabilities are “obligations whose liquidation is reasonably expected to require use of
existing resources properly classified as current assets, or the creation of other current liabilities.”
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.

CLASSIFICATION OF CURRENT LIABILITIES

 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.

1. Trade Accounts Payable

Trade accounts payable resulted from purchases of goods and services on account.
Consider for example xyz co. purchased goods worth Br. 100,000 on account with a credit term of
2/10, n/30.
n/30.

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At the time of purchase: purchase 100,000
Accounts payable 100,000
 Payment within 10 days: Accounts payable 100,000
Cash 98,000
Purchase discount 2,000
 Payment after 10th day: Accounts payable 100,000
Cash 100,000
2. promissory 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.
Assume that in November 1, year 9, unity Co. uses a one-year non-interest 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
Solution
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
3. Cash Dividends
A company may declare a cash dividend, a property dividend (a dividend payable in property
other than cash), or a scrip dividend (a dividend that creates a promissory note). When a company

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declares a dividend, it reduces retained earnings and recognizes a current liability if it expects to
distribute the dividend in the coming year or operating cycle. These dividends are recorded and
reported at the amount to be paid. The liability is titled Dividends Payable. And it can be recorded
as follows;
Retained earnings . . . . . . . . . xx
Dividend payable . . . . . . . . . . xx
4. Accrued Liabilities/accrued expenses
Accrued liabilities are obligations that accumulate in a systematic way over time. For
convenience, a company usually waits until the end of the accounting period to make adjusting
entries to record these liabilities and the related expenses. Most accrued liabilities are current
liabilities. Some are definite in amount, while the amounts of others are based on operations or
estimates. For example;
ACCRUED SALARY:
SALARY: there are various deductions to calculate the liability for take home 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 xx
Payroll Taxes Expenses xx
Taxes payable xx
Salaries payable xx
5. Unearned revenues
A company’s unearned items (sometimes called deferred revenues) include amounts that it has
collected in advance for future sales but has not yet earned and has not recorded as revenues.
These unearned items are liabilities because it has not yet provided the product or service.
Some examples of unearned items are amounts collected in advance, such as interest, rent, gift
certificates, and service contracts.
To illustrate, assume that Manchester united football club sells 10,000 season football tickets at
$50 each for its five-game home schedule. The club records the sales of season tickets as follows;
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: indemnity
fund retained by commercial companies

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  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 includes: sales tax, income taxes, bonus, royalties, etc.

 Sales Taxes Payable

A sales tax is a tax levied on the transfer of tangible personal property and on certain services. A
seller must collect sales tax from the customer and pay the amount usually on a monthly basis to
the proper governmental authority. The Sales Taxes Payable account should reflect the liability
for sales taxes due various governments.
For example: matyo retailing co. sold 3000 units of supplies with a sales price of Birr 5 and a
sales tax of 2 % is in effect. The entry will be as follows;
 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.
Income tax expense xx
Income tax payable xx
 BONUS
Many companies give a bonus to certain or all employees in addition to their regular salaries or
wages. Frequently the bonus amount depends on the company’s yearly profit (after deduction of
expenses). 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:
(1) Income before income taxes and bonus
(2) Income after bonus but before income taxes
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 (3) Net income (i.e. income after bonus and income taxes)

For example, assume that Gift Trading has a bonus plan under which marketing staff receives
25% of the income over Br. 35, 000 earned by the business. Income for the business amounted to
Br. 95, 000 before the bonus and income taxes. The income tax rate is assumed to be 35%.
Calculate the bonus expenses for Gift Trading under each of the following assumptions.

Assumption 1 – Bonus is calculated based on income before income taxes and bonus
Bonus = 0.25 (95, 000 – 35, 000) = Br. 15, 000
Assumption 2 – Bonus is calculated based on income after bonus but before income taxes Let B
refers to bonus
Bonus = 0.25 (95, 000 – 35, 000 – B)
B = 15, 000 – 0.25 B  B = Br. 12, 000
Assumption 3 – Bonus is calculated based on income after bonus and income taxes
Let B refers to bonus
T refers to income taxes
B = 0.25 (95, 000 – 35, 000 – B – T)  B = 15, 000 – 0.25B – 0.25T…..(1)
T = 0.35 (95, 000 – B)  T = 33, 250 – 0.35 B……………(2)
Substituting (2) in (1),
B = 15, 000 – 0.25 B – 0.25 (33, 250 – 0.35 B)
 B = 15, 000 – 0.25 B – 8312.5 + 0.0875 B
1.1625 B = 6, 687.5
 B = 5752.69 (Rounded to two decimal places)
Note that the journal entry in all three cases respectively is
Bonus Expense 15,000 12,000 5,752.69
Bonus payable 15,000 12,000 5,752.69

 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.
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 There are three levels in the expectation of recurrence of future events, which in turn dictates their
treatment – accrual, disclosure, or neither of them. Future events may be:
 Probable- likely to occur
 Reasonably possible-more than remote but less than likely, or
 Remote – slight chance of occurring
LOSS CONTINGENCIES
Loss contingencies involve possible losses. A liability incurred as a result of a loss contingency is
by definition a contingent liability. Contingent liabilities depend on the occurrence of one or more
future events to confirm the amount payable, the payee, the date payable, or its existence.
Examples include;
1. Usually Accrued
Loss Related to:
 Collectability of receivables
 Obligations related to product warranties and product defects
2. Not Accrued
Loss Related to:
 Risk of loss or damage of enterprise property by fire, explosion, or other hazards
 Risk of loss from catastrophes assumed by property and casualty insurance companies
3. May Be Accrued*
Loss Related to:
 Pending or threatened litigation
 Guarantees of indebtedness of others
 Selling of receivable or other assets through recourse
*Should be accrued when both criteria—probable and reasonably estimable—are met.
To explain their accounting treatment, scrutinize the following table:

Probability as to the Contingency can be Contingency cannot be

existence reasonably estimated Reasonably estimated
of loss contingency
(1) Probable Accrued & included in the financial Not accrued but reported in a note
statements to the financial statements
(2) Reasonably Possible Not accrued, but reported in a note Not accrued, but reported in a note
to the financial statements to the financial statements

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(3) Remote Not accrued, a note to the financial Not accrued, a note to the financial
statements is permitted but not statements is permitted but not
required required

 Accrual of loss contingencies

As can be seen and implied from the above table, a loss contingency is accrued
(a) Only when it is probable that an asset has been impaired or a liability incurred
(b) The amount of the loss can be reasonably estimated, and
(c) It must be probable that a future event will confirm the existence of the loss
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. To illustrate,
assume that Tiret Company had a lawsuit on the balance sheet date but the amount of the damage
has not been yet decided. A reasonable estimate of the compensation is between Br. 300, 000 and
Br. 700, 000, no amount in between is a better estimate than any other. Tiret Company records
this as follows:
Litigation Loss 300, 000
Liability from litigation 300, 000
The Company also discloses the additional Br. 400, 000 (i.e. Br. 700, 000 – Br. 300, 000) in the
note to the financial statements.
Accruable loss contingency with their accounting treatment