Current Liabilities and Contingencies

Overview
With the discussion of investments in the previous chapter, we concluded our three-chapter coverage of
assets that began in chapter 6. This is the first of five chapters devoted to liabilities. Here, we focus on short-
term liabilities. Bonds and long-term notes are discussed in the next chapter. Obligations relating to leases,
income taxes, pensions, and other postretirement benefits are the subjects of the following three chapters. In
part A of this chapter, we discuss liabilities that are classified appropriately as current. In part B, we turn our
attention to situations in which there is uncertainty as to whether an obligation really exists. These are
designated as loss contingencies or contingent liabilities.

Learning Objectives
1. Define liabilities and distinguish between current and long-term liabilities.
2. Account for the issuance and payment of various forms of notes and record the interest on the notes.
3. Characterize accrued liabilities and liabilities from advance collection and describe when and how they
should be recorded.
4. Determine when a liability can be classified as a noncurrent obligation.
5. Identify situations that constitute contingencies and their accounting treatment.
6. Understand the differences between provisions and contingencies and know the appropriate accounting
treatment for different types of provisions, including those arising from constructive obligations.
7. Appreciate the differences between IFRS and US GAAP regarding current liabilities and contingencies.
Lecture Outline
Part A: Current Liabilities

I. Characteristics of Liabilities
A. Most liabilities obligate the debtor to pay cash at specified times and result from legally enforceable
agreements.
B. Obligations may arise from contracts, statutory requirements, normal business practice, custom, and a
desire to maintain good business relations or to act in an equitable manner
C. Some liabilities are not contractual obligations and may not be payable in cash.
D. A liability is a (1) present obligation arising from (2) past events, the settlement of which is (3)
expected to result in an outflow from resources in the future.
II. What is a Current Liability?
A. Classifying liabilities as either current or long-term helps investors and creditors assess the relative
risk of a business’s liabilities.
B. Current liabilities usually are payable within one year or in the normal operating cycle.
C. However, in other situations, a firm should classify a liability as current when:
1. it holds the liability primarily for the purpose of trading or
2. “does not have an unconditional right to defer settlement of the liability for at least 12 months
after the reporting period".
D. Current liabilities ordinarily are reported at their maturity amounts.
1. Practical expediency
2. Conceptually, liabilities should be recorded at their present values.
3. Relatively short time to maturity
4. Where the time value of money is material, IAS No. 37 (Contingent Assets) requires the liability
to be measured at its present value.
III. Open Accounts and Notes
A. Accounts payable and trade notes payable
1. Accounts payable—Buying merchandise on account in the ordinary course of business creates
accounts payable.
2. Trade notes payable—Formally recognized by a written promissory note; sometimes bear interest.
B. Short-term notes payable
 1. Line of credit—allows a company to borrow cash without having to follow formal loan
procedures and paperwork.
2. Interest on notes—Principal amount × annual rate × time to maturity
3. Noninterest-bearing notes—Interest is “discounted” from the principal amount of a note; the
effective interest rate is higher than the stated discount rate.
4. Secured loans—A specified asset (often fixed assets or accounts receivable) is pledged as
collateral or security for the loan.
C. Commercial paper
1. Large, highly rated firms
2. Lower rate than through a bank loan
3. Unsecured notes sold in minimum denominations of say $25,000
4. Maturities often ranging from 30 to 270 days
5. Interest often discounted at the issuance of the note
6. Usually backed by a line of credit
7. Recording its issuance and payment exactly the same as forms of notes payable

IV. Accrued Liabilities

A. Represent expenses already incurred, but for which cash has yet to be paid (accrued expenses)
B. Recorded by adjusting entries at the end of the reporting period
C. Common examples: salaries and wages payable, income taxes payable, and interest payable
D. There are two types of compensated absences or paid vacation leave:
1. Accumulated compensated absences: where the employees can use current and past leave
entitlement in future periods.
a. The employer recognizes the expected cost of the employee benefits in the same period when
the employee renders service.
b. The employer has a current obligation to allow employees to use vacation leave in future
periods because of services rendered in the past.
2. Non-accumulating compensated absences: unused leave expires and are not carried forward to a
future period.
a. The employer recognizes the expense on the paid leave only when the leave is utilized.
E. An employer accrues an expense and related liability for employees' accumulating compensated
absence because the obligation meets the following conditions:
1. Past event: Employees have already performed services required to earn their right to
compensated absences.
2. Existing obligation: In accumulating compensated absence, employers have an existing
obligation to allow employees to take their unused leave in future periods or to pay for unused
leave.
a. Benefits under accumulating compensated absences may be either vesting (employees will be
paid the monetary equivalent of unutilized benefits at the end of employment) or non-vesting
(employees are not entitled to a cash payment for unused leave at the end of employment).
3. Future outflow of benefits: The paid absence can be taken in a future period or there is a
monetary payment for leave that is unused.
V. Liabilities From Advance Collection
A. Deposits and advances from customers
1. Collecting cash from a customer as a refundable deposit or as an advance payment for products or
services
2. The advance payment of cash or the payment of a deposit is a past event that creates a current
obligation for the receiving entity to transfer resources or perform a service in the future.
3. Deposits may be either refundable or nonrefundable and in either situation, the receiving entity
recognizes a liability when the deposit is received.
4. Creates a liability to return the deposit or to supply the products or services.
B. Collections for third parties
 1. Sales taxes collected from customers represent liabilities until remitted.
2. Payroll-related deductions such as withholding taxes, social security taxes, employee insurance,
employee contributions to retirement plans, and union dues (discussed in the Appendix).
VI. A Closer Look at the Current and Noncurrent Classification
A. Current maturities of long-term debt
1. The currently maturing portion of a long-term debt must be reported as a current liability.
2. Long-term liabilities that are due on demand (callable)—by terms of the contract or violation of
contract covenants—must be reported as current liabilities.
a. Conversely, even if the obligation is due within a shorter period, the long-term classification
applies if the borrowing entity expects and has the discretion to refinance or roll over an
obligation for at least 12 months after the reporting period.
b. If the debt becomes callable due to a default (i.e. by violation of contract covenant), and the
creditor extends a grace period, the long-term classification would still apply if the following
conditions are met:
i. the lender agrees to the grace period on or before the end of the reporting period
ii. the grace period ends at least twelve months after the reporting period, during which the
lender cannot demand immediate repayment and
iii. the borrower can make rectification of the violation within the extended grace period. (If
it is probable that the violation will be rectified, the long-term classification holds.)
3. The classification of financial liabilities requires the consideration of the terms of contract
including the date of settlement, the right of the creditor to call back the loan, the right of the
borrower to reschedule the loan repayment, and the provision of a grace period in the event that
the borrower breaches a covenant in the debt agreement.
B. Short-term obligations can be reported as noncurrent liabilities if the company intends, and is able,
to defer settlement or refinance on a long-term basis :
1. The borrower must have an unconditional right at the financial year-end to defer settlement for at
least twelve months.
2. This can be demonstrated by either an existing financing agreement or an actual financing at year
end.
3. The specific form of the long-term refinancing (bonds, bank loans, and equity securities) is
irrelevant when determining the appropriate classification.
4. Events occurring after the financial year end, but before the financial statements are issued, can be
used to clarify the nature of financial statement elements at the reporting date.
5. So, any refinancing obtained after the reporting period cannot be used to alter the financial
statements for that period. However, a note may be disclosed if the event is important to the
decision-making of a firm’s investors.
6. Under US GAAP, however, refinancing after the end of the reporting period, but before the
issuance of financial statements, would still enable a liability to be classified as long term.
7. There are discussions between IASB and FASB to change the definition of “short term” to mean
“within one year”, regardless of the length of the reporting period.

Part B: Contingencies

I. Contingent Liabilities
A. Involves an existing uncertainty as to whether a present obligation exists or whether the outflow of
resources is probable, where the uncertainty will be resolved only when some future event occurs
B. By IAS No. 37’s definition, contingent liabilities differ from ordinary liabilities in that they have
uncertainties with respect to either:
1. the existence of a present obligation (i.e., a guarantor in a guarantee agreement that has not been
called upon) or
2. the probability or amount of the future outflow of benefits (i.e., possible damages from pending
litigations).
 C. A contingent liability is never accrued, but is only disclosed in the footnotes to the financial statements
(it is “off balance sheet”).
1. The reporting entity must:
a. describe the nature of the contingent liability and
b. provide an estimate of the financial effect.
2. And if practicable
a. Indicate the uncertainties relating to the amount and timing of the outflows and
b. State the possibility of any reimbursement.
3. Note that the cause of the uncertainty must occur before the financial statement date.

II. Provisions
A. A provision is a liability as it has all the three characteristics of a one.
1. A (1) past obligating event has occurred, the entity is (2) presently obligated, and there is a (3)
future outflow of benefits.
2. The only uncertainties are in the timing and amount of the future outflow of benefits.
3. It is distinguished from a contingent liability in that there is no uncertainty in the existence of the
obligation.
B. In the case of a guarantee, a default would change the possible obligation of the guarantor to a present
obligation. Thus, the guarantor would have to assess the timing and amount of future payments to the
lender to determine whether a provision should be recognized in place of the contingent liability.
C. Provisions are not “off balance sheet” and are recognized in the statement of financial position if they
fulfill all the definition and recognition criterions embodied in the three conditions below.
1. “An entity has present obligation (legal or constructive) that arises as a result of a past event.
2. It is probable that an outflow of resources will be required the settle the obligation.
3. A reliable estimate can be made of the amount of the obligation.”
D. Condition 1: Obligations can be legal or constructive:
a. A legal obligation stems from contractual terms (whether explicit or implied), legislation
(whether existing or those certain to be enacted as drafted), or other operations of law.
b. A constructive obligation stems from a valid expectation formed by other parties.
i. A valid expectation is formed when an entity indicates, through explicit communications
or implicit representations and actions, that it will discharge certain responsibilities to the
parties.
c. For constructive or legal obligations to exist, an obligating event must have occurred.
E. Condition 2: The outflow must be probable:
a. “Probable” in the context of IAS No. 37 is when an event will, “more likely than not”, occur.
b. “More likely than not” is not explicitly defined, but one should always assume a lower
probability threshold than what is implied by the term “probable.”
F. Condition 3: There must be a reliable estimate of the obligation amount:
a. The amount of provision to recognize should be:
i. The “best estimate of the expenditure to settle the present obligation at the end of the
reporting period.” Which is the “amount that an entity would rationally pay to settle or
transfer” the liabilities to a third party at reporting date.
ii. Discounted if the time value of money is material.
b. As IAS No. 37 expects that an entity will be able to determine an estimate in most cases and an
exception to this third test is deemed to be extremely rare.
c. An expected value approach may be used to determine the amount of provision required using
a probability-weighted distribution. It can be used when there is (1) a large population of items
or (2) a large number of possible outcomes.
G. An onerous contract is one in which “the unavoidable costs of meeting the obligations under the
contract exceed the economic benefits expected to be received under it.”
 a. The unavoidable costs of meeting the obligations under a contract reflect the “least net cost of
exiting from the contract, which is the lower of the cost fulfilling it and any compensation or
penalties arising from failure to fulfill it.”
b. When a contract becomes onerous:
i. An impairment loss on assets dedicated to that contract should be recognized under IAS
No. 36
ii. Then, the present obligations under the contract should be recognized and measured as a
provision.
c. Executory contracts (i.e., purchase or sales contracts) which are normally accounted for as
“off-balance sheet” items until the date of their execution would fall under the accounting
requirements of IAS No. 37 if and when the contract becomes onerous.

III. Product Warranties, Litigation Claims, and Subsequent Events

A. Provisions for product warranties are almost are always accrued.
a. The recognition and measurement criterions are that of any standard provisions.
B. Revenue for a separately priced extended warranty contract is deferred as a liability initially and is
usually recognized (typically on a straight line basis) over the life of the contract (i.e. the period during
which the service is performed).
a. The costs incurred to satisfy customer claims under the extended warranties also will also be
recorded during the contract period, achieving a proper matching of revenues and expenses.
b. If the customers' claims will be incurred on another-than-straight-line basis, both the costs and
revenues should be recognized on the same pattern.
C. Accrual of a loss from pending or ongoing litigation is rare
a. Doing so might jeopardize one's position in court as the act of accruing could be construed as
an admission.
b. Today’s legal environment the outcome of litigation is highly uncertain, making likelihood
predictions difficult
D. When the cause of a loss contingency occurs before the year-end, an adjusting event before financial
statements are issued can be used to determine how the contingency is reported.
a. Adjusting events are events (1) that occur in the period between the end of a company’s
financial year and the financial statements authorization date and (2) that provide evidence of
conditions that existed at the end of the reporting period.
b. If an event giving rise to a loss contingency occurs after the year-end, a liability should not be
accrued. Instead, a disclosure note should be made.

IV. Contingent Assets

A. Contingent assets are not accrued.
B. Conservatism
C. A contingent asset’s development should be assessed for changes in the probability of inflow of
economic benefit. When the probability increases from “probable” to “virtually certain” an asset and
related income should be recognized.
D. We accrue a contingent liabilities under IFRS if it’s both probable and can be estimated reliably. US
GAAP is similar, but the threshold is “probable.” This is a higher threshold than “more likely than
not.”
E. Another difference in accounting relates to whether to report a long-term contingency at its principal
value or its present value. Under IFRS, present value of the estimated cash flows is reported when the
effect of time value of money is material. According to US GAAP, though, discounting of cash flows
is allowed when the timing of cash flows is certain.

Decision Makers’ Perspective

A. Liabilities impact a company’s liquidity.
B. Liquidity refers to a company's cash position and overall ability to obtain cash in the normal course of
business.
C. Critical that managers as well as outside investors and creditors maintain close scrutiny of a
company’s liquidity.
D. The current ratio is a measure of short-term solvency.
1. Determined by dividing current assets by current liabilities
2. Should be evaluated in the context of the industry in which the company operates and other
specific circumstances
3. But one indication of liquidity
4. Acid-test or quick ratio, by eliminating current assets such as inventories and prepaid expenses
that are less readily convertible into cash, provides a more rigorous indication of a company's
short-term solvency.
E. Outside analysts as well as managers should actively monitor risk management activities.