CHAPTER THREE

CURRENT LIABILITIES AND CONTINGENCIES

What is a Liability?
 The FASB, as part of its conceptual framework study, 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.”
 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?
Here are some typical current liabilities:
1) Accounts payable.
2) Notes payable.
3) Current maturities of long-term debt.
4) Short-term obligations expected to be refinanced.
5) Dividends payable.
6) Customer advances and deposits.
7) Unearned revenues.
8) Sales taxes payable.
9) Income taxes payable.
10) Employee-related liabilities
Accounts Payable
Accounts payable, or trade accounts payable, is 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.

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.
Notes may also be interest-bearing or zero-interest-bearing.
Interest-Bearing Note Issued: Assume that Castle National Bank agrees to lend $100,000 on March 1,
2010, to Landscape Co. if Landscape signs a $100,000, 6 percent, four-month note. Landscape records
the cash received on March 1 as follows:
March 1 Cash 100,000
Notes Payable 100,000
(To record issuance of 6%, 4-month note to Castle National Bank)
Interest----
If Landscape prepares financial statements semiannually, it makes the following adjusting entry to
recognize interest expense and interest payable of $2,000 ($100,000 x 6% x 4/12) at June 30:
June 30 Interest Expense 2,000
Interest Payable 2,000
(To accrue interest for 4 months on Castle National Bank note)
If Landscape prepares financial statements monthly, its adjusting entry at the end of each month is
$500 ($100,000 x 6% x 1/12).

At maturity (July 1), Landscape must pay the face value of the note ($100,000) plus $2,000 interest
($100,000 x 6% x 4/12). Landscape records payment of the note and accrued interest as follows.
July 1 Notes Payable 100,000
Interest Payable 2,000
Cash 102,000
(To record payment of Castle National Bank interest bearing note and accrued interest at
maturity)
Zero-Interest-Bearing Note Issued
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.
To illustrate, assume that Landscape issues a $102,000, four-month, zero-interest
bearing note to Castle National Bank. The present value of the note is $100,000.
Landscape records this transaction as follows.
March 1 Cash 100,000
Discount on Notes Payable 2,000
Notes Payable 102,000
(To record issuance of 4-month, zero-interest-bearing note to Castle National
Bank)
Current Maturities of Long-Term Debt
Companies report as part of their current liabilities the portion that
matures within the next fiscal year.
They categorizes this amount as current maturities of long-term debt.
Companies exclude long-term debts maturing currently as 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 debt issue, or
3) Converted into capital stock.
Short-Term Obligations Expected to Be Refinanced
Short-term obligations are debts scheduled to mature within one year
Some short-term obligations are expected to be refinanced on a long-term
basis.
At one time, the accounting profession generally supported the exclusion of
short-term obligations from current liabilities if they were “expected to be
refinanced.”
Refinancing Criteria
To resolve these classification problems, the accounting profession has
developed authoritative criteria for determining the circumstances under which
short-term obligations may be properly excluded from current liabilities.
A company is required to 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.
2. It must demonstrate an ability to consummate the refinancing.
Conti--
The company demonstrates the ability to consummate the refinancing
by:
(a)Actually refinancing the short-term obligation by issuing a long-
term obligation or equity securities after the date of the balance sheet
but before it is issued; or
(b)Entering into a financing agreement that clearly permits the
company to refinance the debt on a long-term basis on terms that are
readily determinable.
If an actual refinancing occurs, the portion of the short-term obligation to be
excluded from current liabilities may not exceed the proceeds from the new
obligation or equity securities used to retire the short-term obligation.
Dividends Payable
 A cash dividend payable is an amount owed by a corporation to its
stockholders as a result of board of directors’ authorization.
 Dividends payable in the form of additional shares of stock are not
recognized as a liability. Such stock dividends do not require future
outlays of assets or services.
Customer Advances and Deposits:
Current liabilities may include returnable cash deposits received from
customers and employees.
Unearned Revenues
An airline company sells tickets for future flights.
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 delivering goods or rendering services?
1. Upon receipt of the advance, debit Cash, and credit a current liability account identifying the
source of the unearned revenue.
2. Upon earning the revenue, debit the unearned revenue account, and credit an earned revenue
account.
To illustrate, assume that Allstate University sells 10,000 season football tickets at $50 each for
its five-game home schedule. Allstate University records the sales of season tickets as follows:
August 6 Cash 500,000
Unearned Football Ticket Revenue 500,000
(To record sale of 10,000 season tickets)
After each game, Allstate University makes the following entry.
September 7 Unearned Football Ticket Revenue 100,000
Football Ticket Revenue 100,000
(To record football ticket revenues earned)
Employee-Related Liabilities
Companies report as current liabilities the following items related to
employee compensation.
1) Payroll deductions.
2) Compensated absences.
3) Bonuses.
Compensated absences are paid absences from employment—such as
vacation, illness, and holidays.
Companies should accrue a liability for the cost of compensation for future
absences if all of the following conditions exist.
a) The employer’s obligation relating to employees’ rights to receive compensation
for future absences is attributable to employees’ services already rendered.
b) The obligation relates to the rights that vest or accumulate.
c) Payment of the compensation is probable.
d) The amount can be reasonably estimated.
Bonus Agreements
Many companies give a bonus to certain or all employees in addition to their
regular salaries or wages.
A company may consider bonus payments to employees as additional wages and
should include them as a deduction in determining the net income for the year.
To illustrate the entries for an employee bonus, assume that Palmer Inc. shows
income for the year 2010 of $100,000. It will pay out bonuses of $10,700 in
January 2011. Palmer makes an adjusting entry dated December 31, 2010, to
record the bonuses as follows:
Employees’ Bonus Expense 10,700
Profit-Sharing Bonus Payable 10,700
In January 2011, when Palmer pays the bonus, it makes this journal entry:
Profit-Sharing Bonus Payable 10,700
Cash 10,700
1.2 Contingencies
A contingency is “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.”
1.2.1 Gain Contingencies
Gain contingencies are claims or rights to receive assets (or have a liability
reduced) whose existence is uncertain but which may become valid eventually.
The typical gain contingencies are:
1) Possible receipts of monies from gifts, donations, bonuses, 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.
1.2.2 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 either the amount payable, the payee, the date payable, or its existence.
Likelihood of Loss: When a loss contingency exists, the likelihood that the future
event or events will confirm the incurrence of a liability can range from probable
to remote.
The FASB uses the terms probable, reasonably possible, and remote to identify
three areas within that range and assigns the following meanings.
a) Probable. The future event or events are likely to occur.
b) Reasonably possible. The chance of the future event or events occurring is
more than remote but less than likely.
c) Remote. The chance of the future event or events occurring is slight.
Some of the more common loss contingencies are:
1) Litigation, claims, and assessments.
2) Guarantee and warranty costs.
3) Premiums and coupons.
4) Environmental liabilities.
Litigation, Claims, and Assessments: Companies must consider the following factors
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.
Guarantee and Warranty Costs
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.
Warranties and guarantees entail future costs.
These additional costs, sometimes called “after costs” or “post-sale costs,” frequently are significant.
Companies use two basic methods of accounting for warranty costs: (1) the cash basis method and
(2) the accrual method.
 Guarantee and Warranty Costs
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.
Warranties and guarantees entail future costs.
These additional costs, sometimes called “after costs” or “post-sale costs,” frequently are
significant.
Companies use two basic methods of accounting for warranty costs: (1) the cash basis method
and (2) the accrual method.
a) Cash Basis
A company must use the cash-basis method when it does not accrue a warranty liability in the
year of sale either because:
1. it is not probable that a liability has been incurred, or
2. it cannot reasonably estimate the amount of the liability.
b) Accrual Basis
Under the accrual method, companies charge warranty costs to operating expense
in the year of sale.
We refer to this approach as the expense warranty approach.
warranty approach.
Example. Denson Machinery Company begins production on a new machine in July 2010, and sells 100 units at
$5,000 each by its year-end, December 31, 2010. Each machine is under warranty for one year. Denson estimates
based on past experience with a similar machine, that the warranty cost will average $200 per unit. Further, as a
result of parts replacements and services rendered in compliance with machinery warranties, it incurs $4,000 in
warranty costs in 2010 and $16,000 in 2011.
1. Sale of 100 machines at $5,000 each, July through December 2010:
Cash or Accounts Receivable 500,000
Sales 500,000
2. Recognition of warranty expense, July through December 2010:
Warranty Expense 4,000
Cash, Inventory, Accrued Payroll 4,000
(Warranty costs incurred)
Warranty Expense 16,000
Liability under Warranties 16,000
(To accrue estimated warranty costs)
The December 31, 2010, balance sheet reports “Estimated liability under warranties” as a current liability of $16,000,
and the income statement for 2010 reports “Warranty expense” of $20,000.
3. Recognition of warranty costs incurred in 2011 (on 2010 machinery sales):
Liability under Warranties 16,000
Cash, Inventory, Accrued Payroll 16,000
(Warranty costs incurred)
Sales Warranty Approach.
A warranty is sometimes sold separately from the product.
For example, when you purchase a television set or DVD player, you are entitled to the
manufacturer’s warranty.
In this case, the seller should recognize separately the sale of the television or DVD player, with the
manufacturer’s warranty and the sale of the extended warranty.
This approach is referred to as the sales warranty approach.
Companies defer revenue on the sale of the extended warranty and generally recognize it on a
straight-line basis over the life of the contract.
To illustrate, assume you purchase a new automobile from Hanlin Auto for $20,000. In addition to the
regular warranty on the auto (the manufacturer will pay for all repairs for the first 36,000 miles or
three years, whichever comes first), you purchase at a cost of $600 an extended warranty that protects
you for an additional three years or 36,000 miles. Hanlin Auto records the sale of the automobile
(with the regular warranty) and the sale of the extended warranty on January 2, 2010, as follows:
Cash 20,600
Sales 20,000
Unearned Warranty Revenue 600
1.3 Presentation of Current Liabilities
The following illustration presents an excerpt of Best Buy Company’s
financial statements that is representative of the reports of large corporations.
Conti---
Detail and supplemental information concerning current liabilities should
be sufficient to meet the requirement of full disclosure.
A major exception exists when a company will pay a currently maturing
obligation from assets classified as long-term.
 If a company excludes a short-term obligation from current liabilities
because of refinancing, it should include the following in the note to the
financial statements:
1. A general description of the financing agreement.
2. The terms of any new obligation incurred or to be incurred.
3. The terms of any equity security issued or to be issued.
Illustration below shows the disclosure requirements for an actual refinancing situation.
1.4 Presentation Of Contingencies
A company records a loss contingency and a liability if the loss is both probable
and estimable.
But, if the loss is either probable or estimable but not both, and if there is at
least a reasonable possibility that a company may have incurred a liability, it
must disclose the following in the notes.
1) The nature of the contingency.
2) An estimate of the possible loss or range of loss or a statement that an
estimate cannot be made.
Analysis of Current Liabilities
The distinction between current liabilities and long-term debt is important.
Liquidity regarding a liability is the expected time to elapse before its payment.
Liquid company is better able to withstand a financial downturn.
Analysts use certain basic ratios such as:
 net cash flow provided by operating activities to current liabilities,
 the turnover ratios for receivables and inventory, to assess liquidity.
Two other ratios used to examine liquidity are the current ratio and the acid-test ratio.
A. Current Ratio
The current ratio is the ratio of total current assets to total current liabilities.
Current Ratio = Current Asset
Current Liability
The ratio is frequently expressed as coverage of so many times.
Sometimes it is called the working capital ratio because working capital is the excess of
current assets over current liabilities.
Conti---
Eliminating the inventories, along with any prepaid expenses, from
the amount of current assets might provide better information for
short-term creditors.
Therefore, some analysts use the acid-test ratio in place of the current
ratio.
B. Acid-Test Ratio
Many analysts favor an acid-test or quick ratio that relates total
current liabilities to cash, marketable securities, and receivables.
The following shows the formula for this ratio.
Conti--
To illustrate the computation of these two ratios, we use the information for Best
Buy Co. above. Below is the computation of the current and acid-test ratios for Best
Buy.

 From this information, it appears that Best Buy’s current position is adequate.
However, the acid-test ratio is well below 1. A comparison to another retailer,
Circuit City, whose current ratio is 1.68 and whose acid-test ratio is 0.65,
indicates that Best Buy is carrying fewer inventories than its industry counterparts.
THE END