Chapter-02 & 03

Current Liabilities and Contingencies

Definition of Liabilities:

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.” 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.

Definition of Current liabilities:

Current liabilities are “obligations whose liquidation is reasonably expected to require use of
existing resources properly classified as current assets, or the creation of other current
liabilities.”
This definition has gained wide acceptance because it recognizes operating cycles of varying
lengths in different industries. This definition also considers the important relationship
between current assets and current liabilities.

Typical Current Liabilities:

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

Distinction between a current liability and a long-term debt:

Current liabilities are obligations whose liquidation is reasonably expected to require use of
existing resources properly classified as current assets, or the creation of other current
liabilities. Long-term debt consists of all liabilities not properly classified as current
liabilities.

How are current liabilities related by definition to current assets? How are current
liabilities related to a company’s operating cycle?

Current liabilities are obligations whose liquidation is reasonably expected to require the use
of existing resources properly classified as current assets, or the creation of other current
liabilities.
Because current liabilities are by definition tied to current assets and current assets by
definition are tied to the operating cycle, liabilities are related to the operating cycle.

Under what conditions a short-term obligation should be excluded from current

liabilities?
Answer:

An enterprise should exclude a short-term obligation from current liabilities only if (1) it
intends to refinance the obligation on a long-term basis, and (2) it demonstrates an ability to
consummate the refinancing.

Definition of (a) a contingency and (b) a contingent liability

(a) A contingency is defined as an existing condition, situation, or set of circumstances

involving uncertainty as to possible gain (gain contingency) or loss (loss contingency)
to an enterprise that will ultimately be resolved when one or more future events occur
or fail to occur.

Typical Gain Contingencies are:

1. Possible receipts of monies from gifts, donations, asset sales, and so on.
2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favorable outcome.
4. Tax loss carry forwards (Chapter 19).

Gain contingencies are not recorded.

Disclosed only if probability of receipt is high.

Loss Contingencies

 Involves possible losses.

Likelihood of Loss

FASB uses three areas of probability:

 Probable.
 Reasonably possible.
 Remote.

Common loss contingencies:

1. Litigation, claims, and assessments.
2. Guarantee and warranty costs.
3. Premiums and coupons.
4. Environmental liabilities.

(b) A contingent liability is a liability incurred as a result of a loss contingency.

Under what conditions a contingent liability should be recorded?

Answer:

A contingent liability should be recorded and a charge accrued to expense only if:

(a) information available prior to the issuance of the financial statements indicates that it
is probable that a liability has been incurred at the date of the financial statements,
and
 (b) the amount of the loss can be reasonably estimated.

Distinguish between a determinable current liability and a contingent liability. Give two
examples of each type.

A determinable current liability is susceptible to precise measurement because the date of

payment, the payee, and the amount of cash needed to discharge the obligation are reasonably
certain. There is nothing uncertain about (1) the fact that the obligation has been incurred and (2)
the amount of the obligation.

A contingent liability is an obligation that is dependent upon the occurrence or nonoccurrence

of one or more future events to confirm the amount payable, the payee, the date payable, or
its existence. It is a liability dependent upon a “loss contingency.”

Determinable current liabilities—accounts payable, notes payable, current maturities of long

-term debt, dividends payable, returnable deposits, sales and use taxes, payroll taxes, and
accrued expenses.

Contingent liabilities—obligations related to product warranties and product defects,

premiums offered to customers, certain pending or threatened litigation, certain actual and
possible claims and assessments, and certain guarantees of indebtedness of others.

Contrast the cash-basis method and the accrual method of accounting for warranty
costs.

Answer:

Under the cash-basis method, warranty costs are charged to expense in the period in which
the seller or manufacturer performs in compliance with the warranty, no liability is recorded
for future costs arising from warranties, and the period of sale is not necessarily charged with
the costs of making good on outstanding warranties. Under the accrual method, a provision
for warranty costs is made at the time of sale or as the productive activity takes place; the
accrual method may be applied two different ways: expense warranty versus sales warranty
method. But under either method, the attempt is to match warranty expense to the related
revenues.

Problem-01:

Alvardo company sells a machine for Tk. 7,400 under a 12-month warranty agreement that
requires the company to replace all defective parts and to provide the repair labor at no cost to
the customers. With sales being made evenly throughout the year, the company sells 600
machines in 2017 (warranty expenses is incurred half in 2017 and half in 2018). As a result of
product testing, the company estimates that the warranty cost is Tk. 390 per machine (Tk. 170
parts and Tk. 220 labor).

Instructions:
Assuming that actual warranty costs are incurred exactly as estimated, what journal entries
would be made relative to the following facts?
a. Under application of the expenses warranty accrual method for:
i. Sale of machinery in 2017.
ii. Warranty cost incurred in 2017.
iii. Warranty expenses charged against 2017 revenues.
iv. Warranty costs incurred in 2018.
 v. What amount, if any, is disclosed in the Balance sheet as a liability for future
warranty costs as of December 31, 2012, under each method?

Problem-02:

XYZ Company is presently testing a number of new agricultural seeds that it has recently
harvested. To stimulate interest, it has decided to grant to five of its largest customers the
unconditional right of return to these products if not fully satisfied. The right of return
extends for 4 months. XYZ sells these seeds on account for Tk.30, 00,000 on January 2,
2017. Companies are required to pay the full amount due by March 15, 2017.
Instructions:
i. Prepare the journal entry for XYZ at January 2, 2017, assuming XYZ estimates
returns of 20% based on prior experience. (Ignore cost of goods sold.)
ii. Assume that one customer returns the seeds on March 1, 2017, due to unsatisfactory
performance. Prepare the journal entry to record this transaction, assuming this
customer purchased Tk. 2, 00,000 of seeds from XYZ.
iii. Briefly describe the accounting for these sales, if XYZ is unable to reliably estimate
returns.

Problem-03:

Doss Passos Company sells television at an average price of Tk. 900 and also offers to each
customer a separate 3-years warranty contract for Tk. 90 that requires the company to
perform periodic services and to replace defective parts. During 2017, the company sold 300
televisions and 270 warranty contracts for cash. It estimates the 3-years warranty costs as Tk.
20 for parts and Tk. 40 for labor, and accounts for warranties separately. Assume sales
occurred on December 31, 2017, and straight -line recognition of warranty revenues occurs.

Instructions:
i. Record the necessary journal entries in 2017.
ii. What liability relative to these transactions would appear on the December31, 2017,
balance sheet and how would it be classified?
In 2018, Brooks’s corporation incurred actual costs relative to 2014 television warranty sales
of Tk. 2000 for parts and Tk. 4000 for labor.
iii. Record the necessary journal entries in 2018 relative to 2017 television warranties.
iv. What amount relative to the 2017 television warranties would appear on the
December 31, 2018, balance sheet and how would they be classified.

Problem-04:

Mc-Caffy Corporation sells computers under a 2-year warranty contract that requires the
corporation to replace defective parts and to provide the necessary repair labor. During 2014,
the corporation sells for cash 400 computers at a unit price of Tk. 2,500. On the basis of past
experience, the 2-year warranty costs are estimated to be Tk. 155 for parts and Tk. 185 for
labor per unit. (For simplicity, assume that all sales occurred on December 31, 2014.) The
warranty is not sold separately from the computer.
Instructions
i. Record any necessary journal entries in 2014, applying the cash-basis method.
ii. Record any necessary journal entries in 2014, applying the expense warranty accrual
method.
 iii. What liability relative to these transactions would appear on the December 31, 2014,
balance sheet and how would it be classified if the cash-basis method is applied?
iv. What liability relative to these transactions would appear on the December 31, 2014,
balance sheet and how would it be classified if the expense warranty accrual method
is applied?

Problem-05:

Garison Music Emporium carries a wide variety of musical instruments, sound reproduction
equipment, recorded music, and sheet music. Garison uses two sales promotion techniques-
warranties and premiums-to attract customers.
Musical instruments and sound equipment are sold with a 1-year warranty for replacement of
parts and labor. The estimated warranty cost, based on past experience, is 2% of sales. The
premium is offered on the recorded and sheet music. Customers receive a coupon for each
dollar spent on recorded music or sheet music. Customers may exchange 200 coupons and
Tk.20 for an MP3 player. Garison pays Tk.32 for each player and estimates that 60% of the
coupons given to customers will be redeemed.
Garison’s total sales for 2017 were Tk.7,200,000-Tk.5,700,000 from musical instruments and
sound reproduction equipment and Tk.1,500,000 from recorded music and sheet music.
Replacement parts and labor for warranty work totaled Tk.94,000 during 2017. A total of
6,500 players used in the premium program were purchased during the year and there were
1,200,000 coupons redeemed in 2017.

The balances in the accounts related to warranties and premiums on January 1, 2017, were as
shown below.
Inventory of Premiums Tk. 37,600
Premium Liability 44,800
Warranty Liability 136,000

Instructions:

Garison Music Emporium is preparing its financial statements for the year ended December
31, 2017. Determine the amounts that will be shown on the 2017 financial statements for the
following.

(a) Warranty Expense. (d) Inventory of Premiums.

(b) Warranty Liability. (e) Premium Liability.
(c) Premium Expense.