Ch 2 : Current Liabilities and Contingencies

► What is a Liability:
Three Main Characteristics:
1. Present obligation.
2. Arises from past events.
3. Results in an outflow of resources (cash, goods, services).

► What is the Types of Liabilities:

Three are two Types of Liabilities
1. Current Liabilities
2. Non Current Liabilities

► What is a Current Liability?:

Current liability is reported if one of two conditions exists:
1. Liability is expected to be settled within its normal operating cycle; or
2. Liability is expected to be settled within 12 months after the reporting date.

The operating cycle is the period of time elapsing between the acquisition of goods and services
and the final cash realization resulting from sales and subsequent collections.

► Types of Current Liability?:

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

 Accounts Payable (trade accounts payable)

Balances owed to others for goods, supplies, or services purchased on open account.

Illustration:
On October 1, 2011, Landscape Co. Purchased inventory for $10,000 Terms 2/10, n30 from
Mary Co.
Date Accounts Dr. Cr.
October 1 Inventory 10,000
Accounts Payable 10,000

On October 9, 2011, Landscape Co. Paid the amount due to Mary Co.
Date Accounts Dr. Cr.
October 9 Accounts Payable 10,000
Inventory ( $10,000 × 2% ) 200
Cash 9,800

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Ch 2 : Current Liabilities and Contingencies
 Notes Payable
It is a Written promises to pay a certain sum of money on a specified future date.
 Arise from Purchases, financing, or other transactions (Converting A/P to N/P ).
 Notes classified as short-term or long-term.
 Notes may be interest-bearing or zero-interest-bearing.

Interest Bearing Note Zero Interest Bearing Note

The Note Payable Doesn’t include interest The Note Payable Includes Interest
The amount of Note Equal to the The amount of Note More Than the
amount of Credit ( Cash Borrowed ) amount of Credit ( Cash Borrowed )
For Example : For Example :
Amount of Credit = $10,000 Amount of Credit = $10,000
Amount of Note = $10,000 Amount of Note = $12,000

Interest-Bearing Note
Illustration:
On October 1, 2011, Landscape Co Borrowed $120,000 from Castle National Bank by signs
a $120,000, 6 percent, four-month note.

Date Accounts Dr. Cr.

October 1, Cash 120,000
2011 Note Payable 120,000
December 31, Interest expenses 1,800
2011 Interest Payable (120,000x6%x3/12) 1,800
February 1, Interest Payable 1,800
2012 Interest expenses (120,000x6%x1/12) 600
Note Payable 120,000
Cash 122,400

Zero-Bearing Note Issued

Illustration:
On October 1, Landscape issues a $122,400, four-month, zero-interest-bearing note to
Castle National Bank. The present value of the note is $120,000.

Date Accounts Dr. Cr.

October 1, Cash 120,000
2011 Note Payable 120,000
December 31, Interest expenses(120,000x6%x3/12) 1,800
2011 Note Payable 1,800
February 1, Interest expenses (120,000x6%x1/12) 600
2012 Note Payable 600
Note Payable 122,400
Cash 122,400

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Ch 2 : Current Liabilities and Contingencies

 Unearned Revenue
Amounts received before the company delivers goods or provides services.

Accounting Treatment:

1- When Cash is received

Date Accounts Dr. Cr.

Cash $$$$$
Unearned ………………….. $$$$$

2- When Services is performed

Date Accounts Dr. Cr.

Unearned ………………….. $$$$$
………………….. Revenue $$$$$

BE13-6:
Sports Pro Magazine sold 12,000 annual subscriptions on August 1, 2010, for $18 each.
Prepare Sports Pro’s August 1, 2010, journal entry and the December 31, 2010, annual
adjusting entry.

Date Accounts Dr. Cr.

August 1 Cash (12,000 × $18) 216,000
Unearned subscriptions 216,000
December 31 Unearned subscriptions 90,000
Subscriptions Revenue 90,000
(216,000 × 5/12)

 Sales Tax Payable.

 Sales taxes are expressed as a stated percentage of the sales price.
 Retailer collects tax from the customer.
 Retailer remits the collections to the state’s department of revenue.
 Either rung up separately or included in total receipts

Exercise 3:
In Providing accounting services to small business, you encounter the following situations
pertaining to cash sales.
1. Kemer Company rings up sales and sales tax separately on its cash register. On April 10,
the register totals are sales $30,000 and sales tax $1.500.
2. Bodrum company doesn’t segregate sales and sales taxes. Its register total for April 15 is
$23,540, which includes a 7% sales tax.
Instructions
Prepare the entry to record the sales transactions and related taxes for each client

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Ch 2 : Current Liabilities and Contingencies

Solution:
KEMER COMPANY
Apr. 10 Cash ................................................................. 31,500
Sales ................................................................... 30,000
Sales Taxes Payable .......................................... 1,500
BODRUM COMPANY
15 Cash ............................................................... 23,540
Sales ($23,540 ÷ 1.07)...................................... 22,000
Sales Taxes Payable .......................................... 1,540
($23,540 - $22,000)

 Income tax Payable.

Businesses must prepare an income tax return and compute the income tax payable.
 Taxes payable are a current liability.
 Corporations must make periodic tax payments.
 Differences between taxable income and accounting income sometimes occur

 Current Maturity of Long Term Debt.

Portion of bonds, mortgage notes, and other long-term indebtedness that matures within
the next fiscal year.
Exclude long-term debts maturing currently if they are to be:
1. Retired by assets accumulated that have not been shown as current assets,
2. Refinanced, or retired from the proceeds of a new debt issue, or
3. Converted into ordinary shares.

 Short Term Obligations expected to be Refinanced .

Exclude from current liabilities if both of the following conditions are met:
1. Must intend to refinance the obligation on a long-term basis.
2. Must have an unconditional right to defer settlement of the liability for at least 12
months after the reporting date.

 Customers Advances and Deposits .

Returnable cash deposits received from customers and employees.
 May be classified as current or non-current liabilities depends on the time between
the date of the deposit and the termination of the relationship that re- quired the
deposit.
 Companies may receive deposits from customers to guarantee performance of
a contract or service or as guarantees to cover payment of expected future obligations.

 Employee Related Liability .

Amounts owed to employees for salaries or wages are reported as a current liability, it may
includes:
 Payroll deductions.
 Compensated absences: such as vacation, illness, and maternity, paternity, and jury leaves
 Bonuses.

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 Ch 2 : Current Liabilities and Contingencies

► Provisions.
 Provision is a liability of uncertain timing or amount. (also called estimated liability)
 Reported either as current or non-current liability.
 Common types are
► Obligations related to litigation.
► Warrantees or product guarantees.
► Premiums

BE13-10: ( Litigation )
Scorcese Inc. is involved in a lawsuit during 2010.
Instructions:
(a) Prepare the December 31 entry assuming it is probable that Scorcese will be liable for
$900,000 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.

Date Accounts Dr. Cr.

(a) Lawsuit Loss 900,000
Lawsuit Liability 900,000

Date Accounts Dr. Cr.

(b) No entry is necessary
because it is not Probable that a liability
has been incurred at December 31, 2010.

Illustration : (Warranty )
During December 2011, Cap City Inc. introduced a new line of televisions that carry a two-year
warranty against manufacturer's defects. Based on past experience with similar products,
warranty costs are expected to be approximately 1% of sales during the first year of the warranty
and approximately an additional 3% of sales during the second year of the warranty. Sales were
$6,000,000 for the first year of the product's life and actual warranty expenditures were $29,000.
Assume that all sales are on credit.
Required:
1. Prepare journal entries to summarize the sales and any aspects of the warranty for 2011
assuming that actual warranty costs incurred during 2011.
2. What amount should Cap City report as a liability at December 31, 2011?
3. Repeat the answer of (1) and (2) above, assuming the actual warranty costs incurred during
2012.

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Ch 2 : Current Liabilities and Contingencies

Solution

Requirement (1)

Date Accounts Dr. Cr.

During Accounts Receivables 6,000,000
2011 Sales Revenue 6,000,000
TO RECORD 2011 SALES REVENUE
During Warranty Expenses 29,000
2011 Cash 29,000
TO RECORD ACTUAL WARRANTY COSTS
Dec 31 Warranty Expenses 331,000
2011 Warranty Liabilities 331,000
[($6,000,000 × 4%) - $29,000 ]
TO RECORD ESTIMATED WARRANTY

Requirement (2)

Dr. Warranty Liability Cr.

Dec 31 331,000

Ending Bal. 331,000

Requirement (3)

Date Accounts Dr. Cr.

During Accounts Receivables 6,000,000
2011 Sales Revenue 6,000,000
TO RECORD 2011 SALES REVENUE
Dec 31 Warranty Expenses 360,000
2011 Warranty Liabilities 360,000
[($6,000,000 × 4%) ]
TO RECORD ESTIMATED WARRANTY
During Warranty Liability 29,000
2012 Cash 29,000
TO RECORD ACTUAL WARRANTY COSTS

Dr. Warranty Liability Cr.

29,000 Dec 31 360,000

Ending Bal. 331,000

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Ch 2 : Current Liabilities and Contingencies

Premium

Companies offer premiums, coupon offers, and rebates to stimulate sales. Thus, companies should
charge the costs of premiums and coupons to expense in the period of the sale that benefits from
the plan.

Illustration 1 : (Premium )
Albertson Corporation began a special promotion in July 2011 in an attempt to increase sales. A
coupon was placed in each box of product which sold at $10 each. Customers could send in 5
coupons for a free prize. Each prize cost Albertson Corporation $3.00. Albertson's management
estimated that 80% of the coupons would be redeemed. For the six months ended December 31,
2011, the following information is available:

Prizes Purchased 35,000 Prize

Product Sold 200,000 Boxes
Coupons redeemed During 2011 56,000 Coupons

Required:
Prepare all required Journal entries to account for Premium.

Solution:

Date Accounts Dr. Cr.

During Inventory – Prizes (35,000 × $3 ) 105,000
2011 Cash 105,000
TO RECORD THE PURCHASE OF PRIZES
During Cash ( 200,000 × $10 ) 2,000,000
2011 Sales Revenue 2,000,000
TO RECORD THE SALE OF PRODUCT
During Premium Expenses 33,600
2011 Inventory – Prizes 33,600
( 56,000 ÷ 5 ) = 11,200 × $3
TO RECORD THE ACTUAL REDEMTION
During Premium Expenses 62,400
2011 Premium Liability 62,400
TO RECORD ESTIMATED PREMIUM
200,000 *80% = 160,000 - 56,000 = 104.000/5 = 20,800 *$3 = $62,400

Total Coupons 200,000

× Percentage estimated to be redeemed 80%
= Total Estimated Coupons to be redeemed 160,000
- Actual Coupons redeemed 56,000
= Unredeemed Coupons 104,000
÷ Number of Coupons required for each prize 5
= Estimated Number of Prizes 20,800
× Cost Per Prize $3
= Estimated Premium Expenses $ 62,400

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Ch 2 : Current Liabilities and Contingencies

Illustration 2 : (Premium )
Answer illustration 1, assuming that the actual redemption were incurred during 2012 instead of 2011.

Solution:

Date Accounts Dr. Cr.

During Inventory – Prizes (35,000 × $3 ) 105,000
2011 Cash 105,000
TO RECORD THE PURCHASE OF PRIZES
During Cash ( 200,000 × $10 ) 2,000,000
2011 Sales Revenue 2,000,000
TO RECORD THE SALE OF PRODUCT
During Premium Expenses (Computed Below) 96,000
2011 Premium Liability 96,000
TO RECORD ESTIMATED PREMIUM
During Premium Liability 33,600
2012 Inventory – Prizes 33,600
( 56,000 ÷ 5 ) = 11,200 × $3
TO RECORD THE ACTUAL REDEMTION

Total Coupons 200,000

× Percentage estimated to be redeemed 80%
= Total Estimated Coupons to be redeemed 160,000
- Actual Coupons redeemed 0
= Unredeemed Coupons 160,000
÷ Number of Coupons required for each prize 5
= Estimated Number of Prizes 32,000
× Cost Per Prize $3
= Estimated Premium Expenses $ 96,000

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