DySAS Center for CPA Review (DCCPAR)

FINANCIAL ACCOUNTING Cagayan Branch

Review Material Mr. John C. Frivaldo, MBA, CPA

ACCOUNTING FOR INCOME TAXES

Types of Differences:
a. Permanent differences
b. Temporary differences

Format:
Financial income per book xx
(based on GAAP – appearing on FS)
Add(deduct): Permanent differences:
Nondeductible expenses xx
Nontaxable or tax exempt revenues (xx)
Financial income subject to income tax xx
Add (deduct): Temporary differences:
Deductible temporary differences –
a. Bad debts xx
b. Estimated expenses xx
c. Impairment loss/ unrealized loss xx
d. Research cost xx
e. Excess of financial over tax dep’n. xx
f. Cash received in advance xx xx
Taxable temporary differences –
a. Prepayments xx
b. Development costs xx
c. Excess of tax over financial dep’n. xx
d. Sales on account or installment xx
e. Cost recovery method for tax and
percentage of completion for financial xx
f. Unrealized gains xx (xx)
Taxable income xx
(based on applicable tax laws – appearing on income tax returns)

Revenues and expenses which are included either in financial income

or taxable income but will never be included in the other. They do not give
rise to deferred tax asset and liability because of no future tax consequences.
Examples of nontaxable or tax-exempt revenues are: gain from settlement
life insurance of officers and employees where the corporation is the named
beneficiary, dividends received by a domestic corporation or non-resident
corporation from a domestic corporation, and interest income on government
securities (municipal bonds, treasury bills) and deposits.
Examples of non-deductible expenses are: fines and penalties for
violation of law, charitable contributions in excess of tax limitation, and
premiums on life insurance for officers and employees when the company is
the beneficiary.
1. Because an entity uses different methods to depreciate equipment for
accounting and income tax purposes, the entity has temporary differences that
will reverse during the next year and add to taxable income. Deferred income
taxes that are based on these temporary differences shall be classified in the
entity’s statement of financial position as:
(a) Contra account to current assets
(b) Contra account to noncurrent assets
(c) Current liability
(d) Noncurrent liability D

2. Which of the following is the most likely item to result in a deferred tax asset?
(a) using straight line depreciation for the books and accelerated depreciation for
tax
(b) prepayment of insurance
(c) rent received in advance
(d) point of sale revenue recognition for the books and cost recovery method of
revenue recognition for tax
C

3. Permanent differences differ from temporary differences in that:

(a) permanent differences occur more frequently than temporary differences
(b) a permanent difference cannot change its status once designated, but a
temporary difference may be reclassified in a later period
(c) permanent differences do not reverse themselves in subsequent periods
(d) permanent differences are both unusual and infrequent
C

4. A temporary difference which would result in a deferred tax liability is:

(a) interest revenue on municipal bonds.
(b) accrual of warranty expense.
(c) excess of tax depreciation which over financial depreciation.
(d) subscription received in advance.
C

5. At the most recent year-end, an entity had a deferred tax liability arising from
accelerated depreciation that exceeded a deferred asset relating to rent received
in advance which is expected to reverse in the next year. Which of the following
shall be reported in the entity’s most recent year-end statement of financial
position?
(a) the excess of the deferred tax liability over the deferred tax asset as a
noncurrent liability
(b) the excess of the deferred tax liability over the deferred tax asset as a
current liability
(c) the deferred tax liability as a noncurrent liability
(d) the deferred tax liability as a current liability C

6. Which statement is incorrect concerning tax assets and liabilities?

(a) Deferred tax assets and liabilities should be discounted.
(b) Tax assets and liabilities should be presented separately from other assets
and liabilities in the balance sheet.
(c) Deferred tax assets and liabilities should be distinguished from current tax
assets and liabilities.
(d) When an entity makes a distinction between current and noncurrent assets
and liabilities, it should not classify deferred tax assets and liabilities as
current. A

7. An entity’s financial reporting basis of its plant assets exceed the tax basis
because it uses a different method of reporting depreciation for financial
reporting purposes and tax purposes. If it has no other temporary differences,
the entity should report a:
(a) current tax asset (c) deferred tax liability
(b) deferred tax asset (d) current tax payable C

8. Differences between taxable income and pretax accounting income arising from
transactions that, under applicable tax laws and regulations, will not be offset by
corresponding differences or “turn around” in future periods is a definition of:
(a) intraperiod tax allocation (c) timing differences
(b) interperiod tax allocation (d) permanent differences
D
9. A temporary difference which would result in a deferred tax liability is:
(a) accrual of estimated litigation loss
(b) accrual of estimated warranty cost
(c) subscription received in advance
(d) an installment sale which is included in accounting income at the time of sale
and included in taxable income when collected
D

10.Income tax expense is based on:

(a) pretax accounting income (c) pretax gross income
(b) pretax taxable income (d) pretax adjusted gross
income A

11.Mar Company is determining the amount of its pretax financial income for 2008
by making adjustment to taxable income from the company’s 2008 income tax
return. The tax return indicates taxable income of P5,000,000 on which a tax
liability of P1,750,000 has been recognized (P5,000,000 x 35%). Following are
the items that may be required to determine pretax financial income from the
amount of taxable income:
I. Straight line depreciation for income tax purposes was P500,000;
accelerated depreciation for financial accounting purposes is P800,000.
II. Estimated warranty cost was P1,000,000 but only P200,000 was deducted in
the tax return because it is the amount actually paid in the current year.
III. Cash dividend was not included in the tax return because the said cash
dividend is tax-exempt. During the year, cash dividend received was
P400,000.
What was Mar Company’s pretax financial income for 2008?____________

Pretax income P4,300,000

Permanent difference ( 400,000)
Financial income subject to income tax P3,900,000
Temporary differences:
Depreciation P300,000
Warranty costs 800,000 1,100,000
Taxable income P5,000,000

12.On January 2, 2007, Might Company purchased machine for P1,400,000. This
machine has a 5-year useful life, a residual value of P200,000, and is depreciated
using the straight line method for financial statement purposes. For tax
purposes, depreciation expense was P500,000 for 2007 and P400,000 for 2008.
Might’s 2008 income before tax and depreciation expense was P2,000,000 and
its tax rate was 35%. If Might has made no estimated tax payments during
2008, what amount of current income tax liability would Might report in its
December 31, 2008 balance sheet?___________ 560,000 (35%)

Net income before depreciation P2,000,000

Depreciation (1,400,000 – 200,000 / 5) ( 240,000)
Net income before income tax P1,760,000
Income tax (1,600,000 x 35%) ( 560,000)
Net income P1,200,000

Pretax financial income P1,760,000

Excess tax depreciation (400,000–240,000) ( 160,000)
Taxable income P1,600,000

13.R Corp. prepared the following reconciliation of income per books with income
per tax return for the year ended December 31, 2008:
Book income before income taxes P900,000
Add: Construction contract revenue which
will reverse in 2011 120,000
Less: Depreciation expense which will reverse
in equal amounts in each of the next 4 yrs (480,000)
P540,000
R’s effective income tax rate is 35% for 2008. What amount should R report in
its 2008 income statement as a current provision for income taxes?__________
189,000 (35%)
14.Unity Corp. prepared the following reconciliation between pretax accounting
income and taxable income for the year ended December 31, 2008:
Pretax accounting income P1,500,000
Taxable income ( 900,000)
Difference P 600,000
Analysis of difference:
Interest on money market funds P 150,000
Excess of tax depreciation over book
depreciation 450,000
P 600,000
Unity’s effective income tax rate for 2008 is 35%. The depreciation difference
will reverse in equal amounts over the next three years at an enacted tax rate of
35%. In Unity’s 2008 income statement, what amount should be reported as the
current portion of its provision for income taxes?____________ 315,000 (35%)

15.On December 31, 2008, the balance sheet accounts of Simple Company have
the same basis for accounting and tax purposes, except the following:
Carrying amount Tax base Difference
Computer software cost P4,000,000 P 0 P4,000,000
Equipment 15,000,000 12,000,000 3,000,000
Accrued liability – health care 2,000,000 0 2,000,000
In January 2008, Simple Company incurred cost of P6,000,000 in relation to
the development of a computer software product. Considering the technical
feasibility of the product, this cost was capitalized and amortized over 3 years
for accounting purposes using straight line. However, the total amount was
expensed in 2006 for tax purposes.
The equipment was acquired on January 1, 2008 for P20,000,000. The useful
life of the equipment is 4 years with no residual value. The equipment is
depreciated using the straight line for accounting purposes and sum of year’s
digits method for tax purposes.
In January 2008, Simple Company entered into an agreement with its
employees to provide health care benefits. The cost of such plan for 2008 was
P2,000,000. This amount was accrued as expense in 2008 for accounting
purposes. However, health care benefits are deductible for tax purposes only
when actually paid.
The pretax accounting income for 2008 is P13,000,000. The tax rate is 35%
and assume there are no deferred taxes on January 1, 2008.

The December 31, 2008 balance sheet shall report deferred tax liability
at:___________

Computer software cost 4,000,000

Equipment 3,000,000
Taxable temporary difference 7,000,000

Deferred tax liability (7,000,000 x 35%) 2,450,000

The December 31, 2008 balance sheet shall report deferred tax asset at:
___________

Deferred tax asset (2,000,000 x 35%) 700,000

What is the 2008 current tax expense? ___________

Pretax accounting income 13,000,000

Future taxable amount (7,000,000)
Future deductible amount 2,000,000
Taxable income 8,000,000

Current tax expense 2,800,000

The 2008 income statement shall report total income tax expense at: ___________

Current tax expense 2,800,000

 Deferred tax expense 2,450,000
Deferred tax benefit ( 700,000)
Total income tax expense 4,550,000

EMPLOYEE BENEFITS

Employee Benefits – are all forms of consideration given by an entity to their

employees or their dependents and may be settled by payments or provision of
goods or services in exchange for services rendered by their employees (full-time,
part-time, permanent, casual or temporary).

Four Categories of Employee Benefits:

(a) Short-term employee benefits – fall due within 12 months after the
end of the period in which the employees render the related service.
- salaries and wages
- social security contributions
- compensated absences (vacation leave, sickness leave, short-term
disability, maternity or paternity, jury service and military service)
- profit-sharing and bonuses (payable within 12 months after the end
of the period in which the employees render the related service)
- non-monetary benefits ( medical care, housing, cars, and free or
subsidized goods or services) for current employees
Accounting:
(a) no actuarial assumptions are required to measure the obligation or
the cost
(b) no possibility of any actuarial gain or loss
(c) measured on an undiscounted basis
(d) accounts may be recognized – expense, liability, prepaid, or some
other asset account in accordance with another standard
(e) compensated absences – may be accumulating or non-
accumulating
(f) profit-sharing and bonuses – are recognized as expenses, not as
distribution of profits, as they result from employee services and not
from a transaction with the entity’s owners

(b) Post-employment benefits – are payable after the completion of

employment. They are classified as either defined contribution plans
or defined benefit plans. They may be funded or unfunded.
- pensions and other retirement benefits
- post-employment life insurance
- post-employment medical care
Accounting:
(a) Defined contribution plan:
- Entity’s obligation is limited to the amount that it agrees to
contribute to the fund. Benefits received by an employee are
determined by the amount of contributions paid by the entity
(and perhaps also the employee) to a plan or an insurance
company, together with investment returns arising from the
contributions.
- Actual risk (benefits will be less than expected) and investment
risk (assets invested will be insufficient to meet expected
benefits) fall on the employee.
- No actuarial assumptions are required to measure the obligation
or expense.
- No possibility of any actuarial gain or loss.
- Measured on an undiscounted basis (except if they do not fall
due wholly within 12 months after the end of the period in which
the employees render the related service).
- Accounts may be recognized – expense, liability, or prepaid
(b) Defined benefit plan:
- Entity’s obligation is to provide agreed benefits to current and
former employees.
- Actual risk and investment risk falls on the entity. If actuarial or
investment experience are worse than expected, the entity’s
obligation may be increased.
 - Actuarial assumptions are required.
- Possibility of any actuarial gain or loss.
- Measured on a discounted basis because they may be settled
many years after the employees render the related service.
- Accounts may be recognized – expense, liability, or prepaid.
Note that the expense recognized is not necessarily the amount
of contribution for the period.

Income Statement:
The amount recognized as expense or income shall generally comprise
the following:
a. current service cost
b. interest cost
c. expected return on any plan assets and on any reimbursement
rights
d. actuarial gains and losses
e. past service costs
f. effect of any curtailments or settlements

(c) Other long-term employee benefits – fall due wholly within 12 months
after the end of the period in which the employees render the related
service.

- long-service leave or sabbatical leave, jubilee or other long-service

benefits
- long-term disability benefits
- profit sharing, bonuses and deferred compensation (if they are
payable 12 months or more after the end of the period)
Accounting:
(a) actuarial gains and losses are recognized immediately and no
‘corridor’ is applied
(b) all past service cost is recognized immediately
(c) the amount of liability is measured by the net total of the following
amounts:
- the present value of the defined benefit obligation (using
Projected Unit Credit Method) at the balance sheet date
- minus the fair value at the balance sheet date of plan assets (if
any) out of which the obligations are to be settled directly
(d) the amount of expense or income shall generally comprise of the
following:
- current service cost
- interest cost
- expected return on any plan assets and on any reimbursement
right recognized as an asset (at fair value).
- actuarial gains and losses, which shall be recognized
immediately
- past service cost, which shall be recognized immediately
- the effect of any curtailments or settlements
(d) Termination benefits – are payable as a result of either an entity’s
decision to terminate an employee’s employment before the normal
retirement date, or an employee’s decision to accept voluntary
redundancy in exchange for those benefits.
Accounting:
(a) recognize as expense since no future benefits are expected
(b) use discount rate if termination benefits fall due more than 12
months after
the balance sheet date

Transitional Provisions
On first adopting this Standard, an entity shall determine its transitional liability for
defined benefit plans at that date as:
(a) the present value of the obligation at the date of adoption;
(b) minus the fair value, at the date of adoption, of plan assets (if any) out of which
the obligations are to be settled directly;
(c) minus any unamortized past service cost.
If the transitional liability is more than the liability that would have been recognized
at the same date under the entity’s previous accounting policy, the entity shall
make an irrevocable choice to recognize this increase as part of its defined benefit
liability (transition loss) as follows:
(a) recognize the transition loss immediately to be included in the total benefit
expense for the current period
(b) amortize the transition loss on a straight-line basis over a maximum of five years
from the date of adoption.
If the transitional liability is less than the liability that would have been recognized
at the same date under the entity’s previous accounting policy, the entity shall
recognize that decrease (transition gain) immediately.

1. The most commonly used form of accrued benefit valuation method is:
(a) projected unit credit method (c) individual level premium
method
(b) entry age normal method (d) aggregate method
A

2. Under a defined contribution plan:

I. the entity’s legal or constructive obligation is limited to the amount it agrees
to contribute to the fund.
II. the entity’s obligation is to provide the agreed benefits to current and former
employees.
(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II A

3. These are assets held an entity, the fund itself, that is legally separate from the
reporting entity and exists solely to pay or fund employee benefits.
(a) Plan assets
(b) Trust fund
(c) Retirement fund
(d) Pension assets
A

4. What is incorrect concerning return on plan assets?

(a) The actual return on plan assets is one component of the expense recognized
in the income statement.
(b) The difference between the expected return and actual return on plan assets
is an actuarial gain or loss.
(c) The expected return on plan assets is based on market expectations, at the
beginning of the period, for returns over the entire life of the related
obligations.
(d) In determining the expected and actual return on plan assets, an entity shall
deduct expected administration costs and tax payable by the plan itself.
A

5. It is the excess of the fair value of the plan assets over the present value of the
defined benefit obligation.
(a) Surplus
(b) Projected benefit obligation
(c) Accrued benefit cost
(d) Accumulated benefit obligation A

6. Which is incorrect concerning amortization of past service cost?

I. The past service cost shall be expensed immediately when additional benefits
vest immediately.
II. If the benefits are not vested, the past service cost is amortized on a straight
line basis over the period until the benefits become vested.
(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II D

7. Which is incorrect concerning the basic accounting considerations for a defined

benefit plan?
 (a) The fair value of plan assets is the source of fund set aside in meeting future
benefit payments.
(b) The projected benefit obligation is the present value of expected future
payments required to settle the obligation arising from employee service in
the current and prior periods.
(c) If the fair value of plan assets is more than the projected benefit obligation,
the plan is overfunded and there is prepaid benefit cost.
(d) The fair value of plan assets is classified as noncurrent asset and the
projected benefit obligation is classified as noncurrent liability on the balance
sheet of the entity. D

8. Which statement is correct concerning actuarial gains and losses?

I. Actuarial gains and losses comprise of experience adjustments and the effects
of changes in actuarial assumptions.
II. Actuarial gains and losses may result from increases or decreases in either
the present value of defined benefit obligation or the fair value of any related
plan assets.
(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II C

9. What is the so-called “corridor” in the recognition of actuarial gains and losses?
(a) 10% of the present value of the defined benefit obligation or 10% of the fair
value of plan assets at the beginning of the year, whichever is higher
(b) 10% of the present value of the defined benefit obligation or 10% of the fair
value of plan assets at the beginning of the year, whichever is lower
(c) 10% of the present value of the defined benefit obligation or 10% of the fair
value of plan assets at the end of the year, whichever is higher
(d) 10% of the present value of the defined benefit obligation or 10% of the fair
value of plan assets at the end of the year, whichever is lower
A

10.Any transition loss on first adopting PAS 19 shall be recognized:

I. as expense immediately
II. as expense over a maximum of 5 years
(a) I only
(b) II only
(c) Either I or II irrevocably
(d) Either I or II revocably C

11.Any transition gain on first adopting PAS 19 shall be recognized:

(a) Recognized in income immediately
(b) Deferred and amortized over a maximum of 5 years
(c) Credited to retained earnings
(d) Credited to equity A

12.Which statements is/ are correct concerning a transitional obligation resulting

from the adoption of a defined benefit plan?
I. A transition gain shall be recognized immediately.
II. The transitional obligation is equal to the projected benefit obligation minus
fair value of plan assets and unamortized past service cost at the date of
adoption.
III. A transition loss may be amortized on a straight line basis over a maximum of
5 years.
(a) I and II only
(b) II only
(c) I, II and III
(d) II and III only C

13.On first adopting PAS 19, what is the treatment of a transition loss?
 (a) The entity shall recognize transition loss as expense immediately.
(b) The entity shall amortize the transition loss on a straight line basis over a
maximum of 5 years.
(c) The entity shall make an irrevocable choice whether to expense the transition
loss immediately or to amortize it over a maximum of 5 years.
(d) The entity shall make an irrevocable choice whether to expense the transition
loss immediately or to charge it to retained earnings.
C

14.On January 1, 2008, Bart Company provided the following data in connection
with its defined benefit plan:
Fair value of plan assets P6,500,000
Accrued benefit obligation 7,500,000
The accountant revealed the following information for the year 2006:
Current service cost P1,600,000
Interest cost 10%
Actual return on plan assets 600,000
Expected return on plan assets 8%
Contribution to the plan 1,500,000
Bart Company should report 2008 employee benefit expense at:
(a) P2,350,000 (b) P1,600,000 (c) P1,830,000 (d)
P1,750,000 C

Current service cost P1,600,000

Interest cost (10% x 7,500,000) 750,000
Expected return on plan assets (8% x 6,500,000) ( 520,000)
Benefit expense P1,830,000

Actual return P600,000

Expected return (520,000)
Actuarial gain – deferred P 80,000

Such actuarial gain will be included in the computation of the benefit expense for
the succeeding year under the “corridor” approach.

15.Donna Company has a defined benefit plan with the following details on January
1, 2008:
Expected Actual
Fair value of plan assets P6,000,000 P8,000,000
Accrued benefit obligation 5,500,000 5,500,000
At the beginning of 2008, the enterprise has determined that its average
remaining service period of active employees on such date is 10 years. What is
the amortization of the actuarial gain or loss that will be included in the 2008
employee benefit expense?
(a) P200,000 (b) P120,000 (c) P145,000 (d) P 0
B

Actuarial gain, 1/1/2008 P2,000,000

Corridor (10% x 8,000,000) ( 800,000)
Excess to be amortized P1,200,000
Amortization of actuarial gain (1,200,000/ 10) P120,000

16.On January 1, 2008, Brad Company had a defined benefit plan with the following
details:
Expected Actual
Fair value of plan assets P6,000,000 P8,000,000
Accrued benefit obligation 6,500,000 7,000,000
 Other relevant information for 2008 is as follows:
Current service cost 1,800,000
Interest cost 700,000
Expected return on plan assets 8%
Contribution to the plan 1,500,000
Average service period of employees 5 years
The employee benefit expense to be shown in the 2008 income statement
should be:
(a) P1,500,000 (b) P1,560,000 (c) P1,720,000 (d)
P2,500,000 C

Actual Expected Gain (loss)

FVPA 8,000,000 6,000,000 2,000,000
ABO 7,000,000 6,500,000 ( 500,000)
Net actuarial gain – 1/1/2004 1,500,000
Net actuarial gain – 1/1/2004 1,500,000
Corridor (10% x 8,000,000) ( 800,000)
Excess to be amortized 700,000

Current service cost P1,800,000

Interest cost 700,000
Expected return on plan assets (8% x 8,000,000) ( 640,000)
Amortization of actuarial gain (700,000/ 5) ( 140,000)
Total benefit expense P1,720,000

17.On January 1, 2008, the memorandum records of Grant Company showed the
following balances related to its defined benefit plan:
Fair value of plan assets P9,000,000 Accrued benefit obligation
(P7,500,000)
Unamortized past service cost 500,000 Prepaid/ accrued benefit cost
2,000,000
The remaining average vesting period for the employees covered by the past
service cost is 5 years. The transactions affecting the defined benefit plan for
2008 are as follows:
Current service cost P1,500,000 Contribution to the plan
P1,600,000
Interest cost 800,000 Benefits paid to retirees
1,000,000
Expected and actual return
on plan assets ( 500,000)
The December 31, 2008 balance sheet should show prepaid benefit cost as
noncurrent asset at:
(a) P1,700,000 (b) P2,000,000 (c) P1,900,000 (d)
P1,800,000 A

Current service cost P1,500,000

Interest cost 800,000
Expected return ( 500,000)
Amortization of past service cost (500,000/ 5) 100,000
Total benefit expense P1,900,000

Benefit expense 1,900,000

Cash 1,600,000
Prepaid/ accrued benefit cost 300,000

P/ ABC – 1/1/2008, debit balance P2,000,000

Credit adjustment ( 300,000)
P/ ABC – 12/31/2008, debit balance P1,700,000

18.The following information relates to the defined benefit plan of Zambo Company
on January 1, 2008:
Accrued benefit obligation P15,000,000 Expected return on plan assets
10%
Fair value of plan assets 20,000,000 Settlement discount rate 12%
The actuary provided the following data for the year 2008:
Current service cost P3,000,000
Benefit paid to retirees 1,000,000
Contribution to the plan 1,500,000
 Actual return on plan assets 2,500,000
What is the 2008 employee benefit expense?
(a) P4,800,000 (b) P2,800,000 (c) P3,000,000 (d)
P2,300,000 B

Current service cost P3,000,000

Interest cost (12% x 15,000,000) 1,800,000
Expected return on plan assets (10% x 20,000,000) (2,000,000)
Total benefit expense P2,800,000

19.At December 31, 2008, the following information was provided by Kite
Company’s pension plan administrator:
Fair value plan assets P3,450,000
Accumulated benefit obligation 4,300,000
Projected benefit obligation 5,700,000
What is the amount of the pension liability that should be shown on Kite’s
December 31, 2008 balance sheet?
(a) P5,700,000 (b) P2,250,000 (c) P1,400,000 (d) P850,000
D

Fair value plan assets P3,450,000

Accumulated benefit obligation (4,300,000)
P/ ABC – credit balance (P 850,000)

Under the ASC & IAS, the accrued or accumulated benefit obligation is
used.
The projected benefit obligation is an American standard.

20.The following information pertains to Lee Company’s defined benefit plan for
2008:
Current service cost P1,600,000
Actual and expected gain on plan assets 350,000
Unexpected loss on plan assets related to a disposal
of a subsidiary 400,000
Amortization of unrecognized past service cost 50,000
Annual interest on pension liability 500,000
What amount should be reported as retirement benefit expense in 2008?
(a) P2,500,000 (b) P2,200,000 (c) P2,100,000 (d)
P1,800,000 D

Current service cost P1,600,000

Actual and expected gain on plan assets ( 350,000)
Amortization of unrecognized past service cost 50,000
Annual interest on pension liability 500,000
Total retirement benefit expense P1,800,000
 CURRENT LIABILITIES (PAS 1)/ PROVISIONS, CONTINGENT LIABILITIES,
CONTINGENT ASSETS

Liabilities:
1. Definition – they are present obligations of an entity arising from past
transactions or events, the settlement of which are expected to result in
outflows from the entity of resources embodying economic benefits.
The essential characteristics of a liability are:
a. The liability is the present obligation of a particular entity.
b. The liability arises from past transaction or event.
c. The settlement of the liability requires an outflow of resources
embodying economic benefits.
2. Balance Sheet Classifications –
(a) Current liabilities – are based on the following criteria:
- it is expected to be settled in the entity’s normal operating cycle;
- it is held primarily for the purpose of being traded;
- it is due to be settled within 12 months after balance sheet date;
- the entity does not have an unconditional right to defer settlement of
the liability for at least 12 months after balance sheet date.
Examples of line items, as a minimum, in the face of the statement of
financial position:
- trade and other payables (accounts payable, notes payable, accrued
interest on notes payable, dividends payable and accrued expenses)
- current provisions
- short-term borrowings
- current portion of long-term debt
- current tax liability
(b) Noncurrent liabilities – are those not classified as current such as:
- noncurrent portion of long-term debt
- finance lease liability
- deferred tax liability
- long-term obligations to entity officers
- long-term deferred revenue
3. Treatment of Currently Maturing Long-term Debt that is Refinanced
on a Long-term Basis –
(a) Current – if the original term was for a period longer than 12 months
and an agreement to refinance or to reschedule payment on a long-term
 basis is completed after balance sheet date and before the
financial statements are authorized for issue.
(b) Noncurrent – if the refinancing is completed on or before balance
sheet date and the refinancing is an adjusting event. Also, if the entity
has the discretion to refinance or roll over an obligation for at least 12
months after balance sheet date under an existing loan facility even if
it would otherwise be due within a shorter period, for the reason that the
entity has the unconditional right to defer settlement of it for at least
12 months after balance sheet. Note that the refinancing or rolling over
must be at the discretion of the entity; otherwise, such obligation is
classified as current liability.
4. Effect of Breach of Covenants –
(a) Current – the liability becomes payable on demand even if the lender
has agreed not to demand payment after the balance sheet date and
before financial statements are authorized for issue.
(b) Noncurrent – if the lender has agreed on or before balance sheet
to provide a grace period ending at least 12 months after balance sheet
date.

Provisions:
1. Definition – they represent those liabilities of uncertain timing or amount of
the future expenditure required in settlement. They exist on balance sheet
date but the amount is indefinite or the date when the obligation is due is
also indefinite, and in some cases, the payee cannot be identified or
determined. They are equal to estimated liabilities or loss
contingencies that are accrued because they are both probable and
measurable.

2. Recognition - recognized in the balance sheet when, and only when:

(a) an enterprise has a present obligation as a result of a past event;
(b) it is probable (i.e., more likely than not to occur – more than 50% likely)
that an outflow of resources embodying economic benefits will be required
to settle the obligation; and
(c) a best estimate can be made of the amount of the obligation. When
there is a continuous range of possible outcomes and each point in that
range is as likely as any other, the midpoint of the range is used. The use
of expected value method is employed when involving a large population
of items by weighting all possible outcomes by their associated
possibilities.
Contingent Liabilities:
1. Definition – they are:
(a)possible obligations from past events that will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the enterprise; or
(b)present obligations from past events but are not recognized because
they are not probable that an outflow of resources will be required to
settle the obligation, or the obligation cannot be measured reliably.
2. Recognition – should not be recognized but should be disclosed, unless
the possibilities of an outflow of resources are remote. The required
disclosures are brief description of the nature of contingent liability, estimate
of its financial effects, indication of the uncertainties that exist, and
possibility of any reimbursement.
Contingent Assets:
1. Definition – are possible assets from past events whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the enterprise.
2. Recognition – should not be recognized but disclosed where inflows of
economic benefits are probable. The disclosure includes a brief description of
the contingent asset and an estimate of its financial effects. If contingent
assets are only possible or remote, no disclosures are required.
Decision Tree:

Start
 Present obligation No No
as a result of an Possible
ongoing event? obligation?

Yes Yes

Probable No Yes
Outflow? Remote?

Yes No

Reliable No (rare)
estimate?

Yes

Provide Disclose Do nothing

contingent liability

1. Which is incorrect concerning a liability?

(a) An essential characteristic of a liability is that the entity has a present
obligation.
(b) An obligation may be legally enforceable as a consequence of a binding
contact or statutory requirement.
(c) A decision by management to acquire an asset in the future in itself gives rise
to a present obligation.
(d) An obligation normally arises when the asset is delivered or the entity enters
into an irrevocable agreement to acquire the asset.
C

2. Which is not an essential characteristic of an accounting liability?

(a) The liability is the present obligation of a particular enterprise.
(b) The liability arises from past transaction or event.
(c) The settlement of the liability requires an outflow of resources embodying
economic benefits.
(d) The liability is payable to a specifically identified payee.
D

3. For a liability to exist:

(a) There must be a past transaction or event.
(b) The exact amount must be known.
(c) The identity of the party to whom the liability is owed must be known.
(d) There must be an obligation to pay cash in the future.
A

4. A long-term debt falling due within one year should be reported as noncurrent
liability if the following conditions are met (choose the incorrect one):
(a) The original term is for a period of more than one year.
(b) The enterprise intends to refinance the obligation on a long-term basis.
(c) The intent to refinance is supported by an agreement to refinance which is
completed before the issuance of the financial statements.
(d) The intent to refinance is supported by an agreement to refinance which is
completed after the issuance of the financial statements.
D

5. Which will demonstrate an agreement to refinance (choose the incorrect one)?

 (a) Long-term obligation has in fact been issued before the issuance of the
financial statements for the purpose of refinancing.
(b) Equity security has in fact been issued before the issuance of the financial
statements for the purpose of refinancing.
(c) Before the issuance of the financial statements, the enterprise has in fact
entered into a financing agreement that clearly permits the enterprise to
refinance the currently maturing long-term debt on a long-term basis.
(d) Preferred stock has in fact been issued before the issuance of financial
statements for the purpose of obtaining working capital.
D

6. Some obligations that are due to be repaid within the next operating cycle and
expected to be refinanced or “rolled over” should be classified as noncurrent:
(a) If the refinancing or “rolling over” is at the discretion of the enterprise and
the refinancing agreement has been reached before the issuance of the
statements.
(b) If the refinancing or “rolling over” is at the discretion of the enterprise
regardless of whether a refinancing agreement has been reached or not
before the issuance of the statements.
(c) If the refinancing or “rolling over” is not at the discretion of the enterprise.
(d) Subject to no conditions. A

7. Covenants are often attached to long-term borrowing agreements which

represent undertakings by the borrower. Under these covenants, if certain,
conditions related to the borrower’s financial position are breached, the liability
becomes payable on demand. This liability can still be classified as noncurrent:
(a) when the lender has agreed, prior to the issuance of the statements, not to
demand payment.
(b) when it is probable that further breaches or violations will not occur within
one year from balance sheet date.
(c) when the lender has agreed prior to the issuance of the statements not to
demand payment and it is probable that further breaches will not occur
within one year from balance sheet date.
(d) with no conditions. C

8. What is an obligation that definitely exists but the amount of which is uncertain?
(a) contingent liability (c) provision
(b) unearned revenue (d) discounted note payable C

9. An accrued expense can be best described as an amount:

(a) paid and currently matched with earnings.
(b) paid and not currently matched with earnings.
(c) not paid and not currently matched with earnings.
(d) not paid and currently matched with earnings.
D

10.Estimated liabilities are disclosed in financial statements by:

(a) footnote to the financial statements.
(b) showing the amount among the liabilities but not extending to the liability
total.
(c) an appropriation of retained earnings.
(d) appropriately classifying them as regular liabilities in the balance sheet.
D

11.A loss contingency that should be accrued is:

(a) note receivable discounted.
(b) pending lawsuit.
(c) tax in dispute.
(d) estimated claim under a service warranty on new products sold.
D

12.On January 17, 2007, an explosion occurred at a Sims Company plant causing
extensive property damage to area buildings. Although no claims had yet been
asserted against Sims by March 10, 2008, Sims’ management and counsel
concluded that it is likely that claims will be asserted and that it is reasonably
possible Sims will be responsible for damages. Sims’ management believed that
P1,250,000 would be a reasonable estimate of its liability. Sims’ P5,000,000
comprehensive public liability policy has a P250,000 deductible clause. In Sims’
 December 31, 2007 financial statements which were issued on March 25, 2008,
how should this item be reported?
(a) As an accrued liability of P250,000.
(b) As a footnote disclosure indicating the possible loss of P250,000.
(c) As a footnote disclosure indicating the possible loss of P1,250,000.
(d) No footnote disclosure or accrual is necessary.
B

13.A factory owned by an entity was destroyed by fire. The entity lodged an
insurance claim for the value of the factory building and plant, and an amount
equal to one year’s net profit. During the year, there were a number of meetings
with the representatives of the insurance company. Finally, before year-end, it
was decided that the entity would receive compensation for 90% of its claim.
The entity received a letter that the settlement check for that amount had been
mailed, but it was not received before year-end. How should the entity treat this
in its financial statements?
(a) Disclose the contingent asset in the footnotes.
(b) Wait until next year when the settlement check is actually received and not
recognize or disclose this receivable at all since at year-end it is a contingent
asset.
(c) Record 90% of the claim as a receivable as it is virtually certain that the
contingent asset will be received.
(d) Record 100% of the claim as a receivable at year end as it is virtually certain
that the contingent asset will be received, and adjust the 10% next year
when the settlement check is actually received.
C

14.A retail store received cash and issued gift certificate that is redeemable in
merchandise. When the gift certificate was issued, a:
(a) deferred revenue account should be decreased.
(b) deferred revenue account should be increased.
(c) revenue account should be decreased.
(d) revenue account should be increased. B

15.Magazine subscriptions collected in advance are treated as:

(a) contra account to magazine subscriptions receivable.
(b) deferred revenue in the liability section.
(c) deferred revenue in the stockholders’ equity section.
(d) magazine subscription refunds in the income statement in the period
collected. B

16.During 2008, Might Company filed suit against West Company seeking damages
for patent infringement. At December 31, 2008, Might’s legal counsel believed
that is was probable that Might would be successful against West for an
estimated amount of P1,500,000. In March 2009, Might was awarded
P1,000,000 and received full payment thereof. In Might’s 2008 financial
statements issued February 2009, how should this award be reported?
(a) As a receivable and revenue of P1,000,000.
(b) As a receivable and deferred revenue of P1,000,000.
(c) As a disclosure of a contingent asset of P1,000,000.
(d) As a disclosure of a contingent asset of P1,500,000.
D

17.In packages of its products, Cork Company includes coupons that may be
presented to grocers for discounts on certain products of Cork on or before a
stated expiration date. The grocers are reimbursed when they send coupons to
Cork. In Cork’s experience, 40% of the coupons are redeemed, and one month
generally lapses between the date a grocer receives a coupon from a customer
and the date Cork receives it. During 2007, Cork issued two series of coupons as
follows:
Consumer Amount disbursed
 Issued on Total value expiration date as of 12/31/2007
1/1/2007 P100,000 6/30/2007 P34,000
7/1/2007 120,000 12/31/2007 P40,000
Cork’s December 31, 2007 balance sheet should include a liability for
unredeemed coupons of:
(a) P 0 (b) P8,000 (c) P14,000 (d) P48,000 B

18.On April 1, 2007, Ash Corporation began offering a new product for sale under a
one-year warranty. Of the 50,000 units in inventory at April 1, 2007, 30,000 had
been sold by June 30, 2007. Based on its experience with similar products, Ash
estimated that the average warranty cost per unit sold would be P8. Actual
warranty costs incurred from April 1 through June 30, 2007, were P70,000. At
June 30, 2007, what amount should Ash report as estimated warranty liability?
(a) P90,000 (b) P160,000 (c) P170,000 (d) P330,000
C
Warranty expense (30,000 x 8) P240,000
Less: Actual warranty cost 70,000
Warranty liability – June 30, 2007 P170,000

19.Real Company sells gift certificates, redeemable for store merchandise that
expire one year after their issuance. Real has the following information
pertaining to its gift certificates sales and redemptions:
Unredeemed at 12/31/2006 P75,000
2007 sales 250,000
2007 redemptions of prior year sales 25,000
2007 redemptions of current year sales 175,000
Real’s experience indicates that 10% of gift certificates sold will not be
redeemed. In its December 31, 2007 balance sheet, what amount should Real
report as unearned revenue?
(a) P125,000 (b) P112,500 (c) P100,000 (d) P50,000 D
2007 sales (250000 x 90%) P225,000
Less: 2007 redemptions of current year sales 175,000
Unearned revenue – 12/31/2007 P 50,000
Unredeemed – 12/31/2006 P 75,000
Less: 2007 redemptions of prior year sales 25,000
Expired gift certificates P 50,000

20.Marr Company sells its products in reusable containers. The customer is charged
a deposit for each container delivered and receives a refund for each container
returned within two years after the year of delivery. Marr accounts for the
containers not returned within the time limit as being retired by sale at the
deposit amount. Information for 2008 is as follows:
Container deposits at December 31, 2007 from deliveries in:
2006 P150,000
2007 430,000 P580,000
Deposits for containers delivered in 2008 780,000
Deposits for containers returned in 2008 from deliveries in:
2006 P 90,000
2007 250,000
2008 286,000 626,000
In Marr’s December 31, 2008 balance sheet, the liability for deposits on
returnable containers should be:
(a) P494,000 (b) P584,000 (c) P674,000 (d) P734,000
C
Container deposits on December 31, 2007
from deliveries in 2007 P 430,000
Deposits for containers delivered in 2008 780,000
Total P1,210,000
Less: Deposits for containers returned in 1998
from deliveries in:
2007 P250,000
2008 286,000 536,000
 Liability for container deposits, December 31, 2007 P 674,000
Containers deposits on December 31, 2007
from deliveries in 2006 P 150,000
Less: Deposits for containers returned in 2008
from deliveries in 2006 90,000
Expired and no longer refundable P 60,000

21.Dix Company operates a retail store and must determine the proper December
31 2007 year-end accrual for the following expenses:
(a) The store lease calls for fixed rent P12,000 per month, payable at the
beginning of the month, and additional rent equal to 6% of net sales over
P2,500,000 per calendar year, payable on January 31 of the following year.
Net sales for 2000 are P4,500,000.
(b) An electric bill of P8,500 covering the period December 16, 2007 through
January 15,2008 was received January 22, 2008.
(c) A P4,000 telephone bill was received January 7, 2008 covering:
Service in advance for December 2008 P1,500
Local and toll calls for December 2007 2,500
In its December 31, 2007 balance sheet, Dix should report accrued liabilities of:
(a) P150,750 (b) P131,000 (c) P128,250 (d) P126,750 D

Accrued additional rent (6% x 2,000,00,) P120,000

Accrued electric bill December 16-31 (8,500 x ½ ) 4,250
Accrued telephone bill for 2007 2,500
Total accrued liabilities P126,750

22.Loob Corporation frequently borrows from the bank in order to maintain

sufficient operating cash. The following loans were at a 12% interest rate, with
interest payable at maturity. Loob repaid each loan on its scheduled maturity
date.
Date of loan Amount Maturity date Term of loan
11/1/2000 P 500,000 10/30/2001 1 year
2/1/2001 1,500,000 7/31/2001 6 months
5/1/2001 800,000 1/31/2002 9 months
Loob records interest expense when the loans are repaid. As a result, interest
expense of P150,000 was recorded in 2001. If no correction is made, by what
amount would 2001 interest expense be understated?
(a) P54,000 (b) P62,000 (c) P64,0000 (d) P72,000 A

January 1 – October 30,2001 (500,000 x 12% x 10/12) P 50,000

February 1 – July 31, 2001 (1,500,000 x 12% x 6/12 ) 90,000
May 1 – December 31, 2001 (800,000 x 12% x 8/12) 64,000
Total interest expense of 2001 P 204,000
Less: Recorded interest expense 150,000
Understatement of interest expense P 54,000

23.Eliot Corporation’s liabilities at December 31, 2007 were as follows:

Accounts payable and accrued interest P200,000
12% note payable issued November 1, 2006
maturing July 1, 2007 60,000
10% debentures payable, next annual principal
installment of P100,000 due February 1, 2008 700,000
On December 31, 2007, Eliot consummated a noncancelable agreement with the
lender to refinance the 12% note payable on a long-term basis, on readily
determinable terms that have not yet been implemented. Both parties are
financially capable of honoring the agreement’s provisions. Eliot’s December 31,
2007 financial statements were issued on March 31, 2008. In its December 31,
2007 balance sheet, Eliot should report current liabilities at:
(a) P200,000 (b) P260,000 (c) P300,000 (d) P360,000C
Accounts payable and accrued interest P200,000
Debentures payable 100,000
Total current liabilities P300,000
24.Included in Ruth Company’s liability balances at December 31, 2008 were the
following:
 10% note payable issued on October 1, 2007, maturing
October 1, 2009 P2,000,000
12% note payable issued on March 1, 2007, maturing
on March 1, 2009 4,000,000
Ruth’s 2008 financial statements were issued on March 31, 2009. Under the
loan agreement for the 10% note payable, Ruth has the discretion to refinance
the obligation for at least twelve months after December 31, 2008. On
December 31, 2008, the entire P4,000,000 balance of the 12% note payable was
refinanced through issuance of a long-term obligation payable lump sum.
What amount of the notes payable should be classified as current on
December 31, 2008?
(a) P6,000,000 (b) P4,000,000 (c) P2,000,000 (d) P 0
D

25.Dean, Inc. has P2,000,000 of note payable due June 15, 2008. At the financial
statement date of December 31, 2007, Dean signed an agreement to borrow up
to P2,000,000 to refinance the note payable on a long-term basis. The financing
agreement called for borrowings not to exceed 80% of the value of the collateral
Dean was providing. At the date of issue of the December 31, 2007 financial
statements, the value of the collateral was P2,400,000. Under the existing loan
facility, Dean has the discretion to refinance or roll over the note payable for at
least 12 months after the balance sheet date. In its December 31, 2007 balance
sheet, Dean should classify note payable as:
Short-term obligation Long-term obligation
(a) P2,000,000 P 0
(b) 400,000 1,600,000
(c) 80,000 1,920,000
(d) 0 2,000,000
D