Liabilities

Appendix 1: Special Liabilities

Oktay Urcan
Contingent Liabilities
Definition: Obligations that might be fulfilled by the firm in the future

Example: Lawsuit penalty

Valuation:
If the likelihood of occurrence is remote, ignore the contingent liability.
If the likelihood of occurrence is possible, disclose the contingent liability in a
footnote.
If the likelihood of occurrence is probable, create a contingent liability.

There are no guidelines on what remote, possible, or probable means.

Contingent Liabilities: Example
A firm is sued for $10,000 due to environmental damages. The firm estimates that it will
probably lose the lawsuit.

Assets = Liabilities + Shareholders’ equity

Contingent Liabilities: Example
A firm is sued for $10,000 due to environmental damages. The firm estimates that it will
probably lose the lawsuit.

Assets = Liabilities + Shareholders’ equity

Lawsuit
$10,000 ($10,000)
opening date

Contingent liability Income Statement:

Loss from contingent liability
Contingent Liabilities: Example
A firm is sued for $10,000 due to environmental damages. The firm estimates that it will
probably lose the lawsuit. Suppose that lawsuit concludes with a $7,000 penalty for the
firm.

Assets = Liabilities + Shareholders’ equity

Lawsuit
$10,000 ($10,000)
opening date
Contingent Liabilities: Example
A firm is sued for $10,000 due to environmental damages. The firm estimates that it will
probably lose the lawsuit. Suppose that lawsuit concludes with a $7,000 penalty for the
firm.

Assets = Liabilities + Shareholders’ equity

Lawsuit
$10,000 ($10,000)
opening date

Lawsuit
($7,000) ($10,000) $3,000
closing date

Cash Contingent liability Gain from contingent liability

Warranties
Definition: Promises given by firms to the buyers to
fix/replace a product sold

They are usually given for a certain period of time.

If future warranty costs are large and could be reliably

estimated, warranties need to be recognized in
financial statements.
Warranties: Example
A firm sells 5 bicycles on January 1, 2015 for $200 each. Each bicycle is sold with 2-year
warranty. The firm estimates that each bicycle will have a warranty cost of $15 each over
the 2-year warranty period. The firm spent $30 in 2015 for warranty claims.

Assets = Liabilities + Shareholders’ equity

Warranties: Example
A firm sells 5 bicycles on January 1, 2015 for $200 each. Each bicycle is sold with 2-year
warranty. The firm estimates that each bicycle will have a warranty cost of $15 each over
the 2-year warranty period. The firm spent $30 in 2015 for warranty claims.

Assets = Liabilities + Shareholders’ equity

Bicycle Sale
$1,000 $1,000
(Jan 1, 2015)

Cash Revenues
(Ignore COGS for simplicity)
Warranties: Example
A firm sells 5 bicycles on January 1, 2015 for $200 each. Each bicycle is sold with 2-year
warranty. The firm estimates that each bicycle will have a warranty cost of $15 each over
the 2-year warranty period. The firm spent $30 in 2015 for warranty claims.

Assets = Liabilities + Shareholders’ equity

Bicycle Sale
$1,000 $1,000
(Jan 1, 2015)
Warranty Prov.
$75 ($75)
(Jan 1, 2015)

Warranty Provision Warranty Expense

Warranties: Example
A firm sells 5 bicycles on January 1, 2015 for $200 each. Each bicycle is sold with 2-year
warranty. The firm estimates that each bicycle will have a warranty cost of $15 each over
the 2-year warranty period. The firm spent $30 in 2015 for warranty claims.

Assets = Liabilities + Shareholders’ equity

Bicycle Sale
$1,000 $1,000
(Jan 1, 2015)
Warranty Prov.
$75 ($75)
(Jan 1, 2015)
Warranty Cost
($30) ($30)
(Dec 31, 2015)

Cash Warranty Provision

Warranties: Example
A firm sells 5 bicycles on January 1, 2015 for $200 each. Each bicycle is sold with 2-year
warranty. The firm estimates that each bicycle will have a warranty cost of $15 each over
the 2-year warranty period. The firm spent $30 in 2015 for warranty claims. Suppose that
the firm spends no money on warranty claims in 2016.

Assets = Liabilities + Shareholders’ equity

Beg Balance
$970 $45 $925
(Jan 1, 2016)
Warranties: Example
A firm sells 5 bicycles on January 1, 2015 for $200 each. Each bicycle is sold with 2-year
warranty. The firm estimates that each bicycle will have a warranty cost of $15 each over
the 2-year warranty period. The firm spent $30 in 2015 for warranty claims. Suppose that
the firm spends no money on warranty claims in 2016.

Assets = Liabilities + Shareholders’ equity

Beg Balance
$970 $45 $925
(Jan 1, 2016)
Close Prov.
($45) $45
(Dec 31, 2016)

Warranty Provision Gain from Warranties

Third-Party Collections
Definition: Collections of money by firms from
customers for other parties

Example: Sales tax

Most of these third-party collections are short-

term liabilities.
Third-Party Collections: Example
A firm sells a car for $20,000 which includes a sales tax of $1,000. Tax collections are
transferred to the government at the end of every month.

Assets = Liabilities + Shareholders’ equity

Third-Party Collections: Example
A firm sells a car for $20,000 which includes a sales tax of $1,000. Tax collections are
transferred to the government at the end of every month.

Assets = Liabilities + Shareholders’ equity

Sale $20,000 $1,000 $19,000

Cash Sales Tax Payable Revenues

Third-Party Collections: Example
A firm sells a car for $20,000 which includes a sales tax of $1,000. Tax collections are
transferred to the government at the end of every month.

Assets = Liabilities + Shareholders’ equity

Sale $20,000 $1,000 $19,000

Sale Tax
($1,000) ($1,000)
Transfer

Cash Sales Tax Payable

Bank Loans

Definition: Money borrowed from a bank for a

specific duration from a pre-specified interest
rate

Loans can be short-term or long-term liabilities.

Bank Loans: Example
Company A borrows $5,000 from Illini Bank for 6 months for an annual interest rate of 10%.

Assets = Liabilities + Shareholders’ equity

Bank Loans: Example
Company A borrows $5,000 from Illini Bank for 6 months for an annual interest rate of 10%.

Assets = Liabilities + Shareholders’ equity

Loan $5,000 $5,000

Cash Loan Payable

Bank Loans: Example
Company A borrows $5,000 from Illini Bank for 6 months for an annual interest rate of 10%.

Assets = Liabilities + Shareholders’ equity

Loan $5,000 $5,000

Loan
($5,250) ($5,000) ($250)
Repayment

Cash Loan Payable Interest Expense

($5,000*10%) / 2