1 LIABILITIES

Technical Knowledge

• To understand the concept of liabilities.

• To describe the nature and type of current and none current liabilities.
• To know the measurement of current and noncurrent liabilities.
• To understand the nature of premiums, warranty liabilities, accrued and deferred liabilities.

A. Definition
Liabilities are present obligations of an entity arising from past transactions or event, the settlement
of which is expected to result in an outflow from the entity of resources embodying economic benefits.

B. Classification of Liabilities

a. Current Liabilities

A liability shall be classified as current when it satisfies any of the following criteria:
a. It is expected to be settled in the entity's normal operating cycle.
b. It is held primarily for the purpose of being traded.
c. It is due to be settled within 12 months after balance sheet date.
d. The entity does not have an unconditional right to defer the settlement of the liability for
at lease 12 months after the balance sheet date.

Trade payables and accruals for employees and other operating costs are part of the working capital
used in the entity's normal operating cycle. Such operating items are classified as current liabilities
even if they are settled more than 12 months after the balance sheet date. When the entity's normal
operating cycle is not clearly identifiable, the duration is assumed to be 12 months.

b. Noncurrent Liabilities

The term "noncurrent liabilities" is a residual definition. All liabilities not classified as current are
classified as noncurrent liabilities.

Examples: a. Noncurrent portion of long-term debt

b. Finance lease liability
c. Deferred tax liability
d. Long-term obligation to company officers
e. Long-term deferred revenue

C. Long-term Debt Falling Due Within One Year

A liability which is due to be settled within 12 months after the balance sheet date is classified as
current even if: a. The original term was for a period longer than 12 months.
b. An agreement to refinance or to reschedule payment on long-term basis is completed
after the balance sheet date and before the financial statements are authorized to
issue.

However, this rule does not apply if the entity has the discretion to refinance or roll over an obligation for
at least 12 months after the balance sheet date under an existing loan facility. In other words, such an
obligation is classified as noncurrent even if it would otherwise due within a shorter period. The reason
for this treatment is that such obligation is considered to form part of entity's long-term refinancing
because the entity has the unconditional right to defer settlement of the liability for at least 12 months
after the balance sheet date. Note that the refinancing or rolling must be at the discretion of the entity.
 Otherwise, if the refinancing or rolling is not at the discretion of the entity, the obligation is classified
as current liability.

D. Current Liabilities in the Balance Sheet

a. Trade and other payables (e.g.. Accounts payable, Notes payable, Accrued expenses, etc.)
b. Income tax payable
c. Short-term borrowings
d. Current portion of long-term debt

E. Estimated Liabilities
Estimated liabilities are obligations which exist on balance sheet date although their amounts is not
definite. In many cases, the date when the obligation is due is not also definite and in some instances,
the exact payee cannot be identified or determined. Estimated liabilities are either current or noncurrent
in nature. Examples includes : estimated liability for premium, warranties, gift certificates, and bonus.

CURRENT LIABILITIES

F. Premiums
Premiums are articles of value such as toys, dishes, silverware and other goods and in some cases
cash payments, given to customers as a result of past sales or sales promotion activities.

In order to stimulate the sale of their products, entities offer premiums to customers in return for product
labels, box tops, wrappers and coupons.

Accordingly, when the merchandise is sold, an accounting liability for the future distribution of the
premium arises and should be given recognition.

The accounting procedures for the acquisition of premiums and recognition of the premium liability:

Proforma entries:

1. When the premiums are purchased:

Premiums xx
Cash/Accounts Payable xx

2. When premiums are distributed to customers:

Premium expense xx
Premiums xx

3. At the end of the year, if premiums are still outstanding:

Premium expense xx
Estimated premium payable xx

Illustration:

Company X manufactures a certain product and sells it at $30 per unit. A soup bowl is offered to
customers on the return of 5 wrappers plus a remittance of $1. The bowl costs $5 and it is estimated
that 60% of the wrappers will be redeemed.

The data for the first year concerning the premium are summarized below:

Sales, 10,000 units at $30 $ 300,000

Soup bowls purchased, 2,000 units at $5 10,000
Wrappers redeemed 4,000
Entries: First Year

1. To record the sales:

Cash $ 300,000
Sales $ 300,000

2. To record the purchase of soup bowls:

Premiums-soup bowl (2,000 x $5) 10,000

Cash 10,000

3. To record the redemption of 4,000 wrappers:

Cash (800 x $1) 800

Premium expense (800 x $4) 3,200
Premiums-soup bow (800 x $5) 4,000

** (4,000 wrappers/5 = 800 bowls distributed)

 4. To record the liability on the premium at the end of the first year:

Premium expense 1,600

Estimated premium payable/liability 1,600

** Wrappers to be redeemed (60% x 10,000 wrappers) $ 6,000

Less: Wrappers redeemed 4,000
Balance $ 2,000

Premiums to be distributed (2,000/5) $ 400

Multiply by 4
Estimated liability at year-end $ 1,600

Financial Statement Classification:

At the end of the year, the accounts related to the premium plan are classified as follows:

Current assets:
Premiums-soup bowl $ 6,000

Current liabilities:
Estimated premium payable/liability $ 1,600

Selling expenses or Distribution costs:

Premium expense $ 4,800

G. Warranty
Home appliances like television sets, stereo sets, refrigerators and the like are often sold under
guarantee or warranty to provide free repair service or replacement during a specified period if the
products are defective.

Such entity policy may involve significant costs on the part of the entity if the products sold prove to
be defective in the future within the specified period of time. Accordingly, at the point of sale, a
liability is incurred.

Two approaches followed in accounting for the warranty cost:

a. Accrual approach
b. Expense as incurred approach

Accrual Approach:

Proforma entries:

1. To record the warranty:

Warranty expense xx
Estimated warranty payable/liability xx

2. When the actual warranty cost is incurred and paid:

Estimated warranty payable/liability xx

Cash xx

At a certain date, the estimate is reviewed to determine the reasonableness and accuracy. The actual
warranty cost is analyzed to validate the original estimate.

3. Thus, if the actual cost exceeds the estimate:

 Warranty expense xx
Cash xx

4. If actual cost is less than the estimate:

Estimated warranty payable/liability xx

Warranty expense xx

Illustration 1:

Assume that TV Company sells 1,000 units of television sets for $900 each for cash. Each television
sets is under warranty for one year and the company has estimated from the past experience that
warranty cost will probably average $50 per unit and that only 60% of the units sold will be returned for
repair. Assume further that the company incurs $18,000 for repairs during the year:

Entries:

1. To record the sales:

Cash $ 900,000
Sales $ 900,000

2. To set up the estimated liability on the warranty:

Warranty expense 30,000
Estimated warranty payable/liability 30,000

**Estimated sets to be returned for repair (60% x 1,000 sets) $ 600

Warranty cost 50
Estimated liability $ 30,000

3. To record the payment of the actual cost:

Estimated warranty payable/liability 18,000
Cash 18,000

Financial Statement Classification:

At the end of the year, the accounts related to the warranty plan are classified as follows:

Balance Sheet

Current liabilities:
Estimated warranty payable/liability $ 12,000

Income Statement
Warranty expense $ 30,000

Expense as Incurred Approach:

The "expense as incurred approach" is the approach of expensing warranty cost only when actually incurred.

Thus, in the preceding example, the actual warranty cost of $18,000 is simply recorded as:

Warranty expense $ 18,000

Cash $ 18,000

Illustration 2:

An entity sells refrigerators that carry a 2-year warranty against defects. The sale and warranty repairs are
made evenly throughout the year. Based on past experience, the entity projects an estimated warranty
cost as a percentage of sales as follows:

First year of warranty 4%

Second year of warranty 10%

Sales and actual warranty repairs for two years are as follows:
2017 2018

Sales $ 5,000,000 $ 6,000,000

Actual warranty repairs 140,000 300,000

The pertinent entries are:

2017

1. To record the sales:

Cash $ 5,000,000
Sales $ 5,000,000

2. To record the warranty expense:

Warranty expense (14% x $5,000,000) 700,000

Estimated warranty payable/liability 700,000

3. To record the actual warranty repairs:

Estimated warranty payable/liability 140,000

Cash 140,000

2018

1. To record the sales:

Cash 6,000,000
Sales 6,000,000

2. To record the warranty expense:

Warranty expense (14% x $6,000,000) 840,000

Estimated warranty payable/liability 840,000

3. To record the actual warranty repairs:

Estimated warranty payable/liability 300,000

Cash 300,000

At this point, on December 31, 2015, the estimated warranty liability is determined as follows:

Warranty expense:
2017 700,000
2018 840,000 1,540,000

Actual warranty expense:

2017 140,000
2018 300,000 440,000

Estimated warranty liability-December 31, 2012 1,100,000

Sales made evenly

To have an easier interpretation or understanding of sales accruing evenly during the year, it is fair to assume that
half of the sales were made on January 1 and the other half on July 1.

Thus, the first contract year under a 2-year warranty of the sales made in January 1, 2017 will be within the Janua
1, 2017 to December 31, 2017, and the second contract year will be within January 1, 2018 to December 31, 2018

The first contract year under 2-year warranty of the sales made in July1,2017 will be within July 1, 2017 to
June 30, 2018, and the second contract year will be within July 1, 2018 to June 30, 2019.

If sales and warranty repairs are made evenly during the year, the warranty expense for 2017and 2018, and the
estimated warranty liability on December 31, 2015 are determined as follows:
 Warranty expense related to 2017 sales

2017
First contract year of January 1, 2017 sales (2,500,000 x 4%) $ 100,000
First contract year of July 1, 2017 sales (2,500,000 x 4% x 6/12) 50,000

2018

First contract year of July 1, 2017 sales (2,500,000 x 4% x 6/12) 50,000

Second contract year of January 1, 2017 sales (2,500,000 x 10%) 250,000
Second contract year of July 1, 2017 sales (2,500,000 x 10% x 6/12)) 125,000

2019

Second contract year of July 1, 2017 sales (2,500,000 x 10% x 6/12)) 125,000

Total warranty expense for 2017 sales $ 700,000

Warranty expense related to 2018 sales

2018

First contract year of January 1, 2018 sales (3,000,000 x 4%) $ 120,000

First contract year of July 1, 2018 sales (3,000,000 x 4% x 6/12) 60,000

2019
First contract year of July 1, 2018 sales (3,000,000 x 4% x 6/12) 60,000
Second contract year of January 1, 2018 sales (3,000,000 x 10%) 300,000
Second contract year of July 1, 2018 sales (3,000,000 x 10% x 6/12)) 150,000

2020

Second contract year of July 1, 2018 sales (3,000,000 x 10% x 6/12)) 150,000

Total warranty expense for 2018 sales $ 840,000

The warranty costs after the December 31, 2018 represent the estimated warranty liability on December 31, 2018.

2017 sales still under warranty after December 31, 2018:

Second contract year of July 1, 2017 sales (2,500,000 x 10% x 6/12)) 125,000

2018 sales still under warranty after December 31, 2018:

First contract year of July 1, 2018 sales (3,000,000 x 4% x 6/12) 60,000
Second contract year of January 1, 2018 sales (3,000,000 x 10%) 300,000
Second contract year of July 1, 2018 sales (3,00,000 x 10% x 6/12)) 150,000
Second contract year of July 1, 2018 sales (3,000,000 x 10% x 6/12)) 150,000

Estimated warranty liability-December 31, 2018 785,000

Estimated warranty liability per book 1,100,000
Decrease in warranty liability (315,000)

Thus the adjustment to decrease the liability in 2018

Estimated warranty liability 315,000

Warranty expense 315,000

H. Value Added Taxes of VAT

Illustration:
a. During a month, an entity sold goods to customers on account for $5,600,000 including value added
taxes of $600,000.

Entry:
Accounts receivable $ 5,600,000
Sales $ 5,000,000
VAT output 600,000

b. In the same month, the entity purchased goods on account from suppliers for $2,240,000 including value
added taxes of $240,000.

Entry:
Purchases 2,000,000
VAT input 240,000 2,240,000
Accounts payable

c. At the end of every month, the VAT input is offset against the VAT output in order to determine the net
liability of the entity.

Thus the entry to recognize the net liability at the end of the month:

Entry:
VAT output 600,000
VAT input 240,000
VAT payable 360,000

d. When paid in the succeeding month:

VAT payable 360,000

Cash 360,000

I. Gift Certificate
Many megamalls, department stores and supermarkets sells gift certificates which are redeemable in
merchandise.

The accounting procedures are:

1. When the gift certificates are sold:

Cash xx
Gift certificates payable xx

2. When gift certificates are redeemed:

Gift certificates payable xx

Sales xx

3. When the gift certificates expire:

Gift certificates payable xx

Forfeited gift certificates xx

** The forfeited gift certificates account is classified as other income.

J. Refundable Deposits
Refundable deposits consists of cash or property received from customers but which are refundable
after compliance with certain conditions. Examples: customer deposits for returnable containers like
bottles, drums, tanks, barrels.

Illustration:

1. A deposit of $1,000 is required from the customer for returnable containers. The containers cost
$800.

Cash $ 1,000
Container's deposit $ 1,000

2. Assume the customer returns the containers:

Container's deposit 1,000

Cash 1,000

3. Assume the customer fails to return the containers:

Container's deposit 1,000

Containers 800
Gain on sale of containers 200
K. Bonus
Large entities often compensate key officers and employees by way of bonus for superior income
realized during the year. The main purpose of this is to motivate them by directly relating their
well-being to the success of the enterprise.

Bonus computation usually has four variations:

1. Bonus is expressed as a certain percent of income before bonus and before tax.
2. Bonus is expressed as a certain percent of income after bonus but before tax.
3. Bonus is expressed as a certain percent of income after bonus and after tax.
4. Bonus is expressed as a certain percent of income afar tax but before bonus.

Illustration:

Income before bonus and before tax $ 4,400,000

Bonus 10%
Income tax rate 32%

a. Before bonus and before tax

Income before bonus and before tax 4,400,000

Bonus percentage 10%
Bonus 440,000

b. After bonus but before tax

B = .10 (4,400,000-B) Proof:

B = 440,000 - .10B Income before bonus and tax 4,400,000
B + .10B = 440,000 Less: Bonus 400,000
1.10B = 440,000 Income after bonus and before tax 4,000,000
B = 440,000/1.10 Multiply by 10%
B = 400,000 Bonus 400,000

c. After bonus and after tax

B = .10(4,400,000-B-T) Proof:
T = .32(4,400,000-B) Income before bonus and tax 4,400,000
B = .10[(4,400,000-B-.32(4,400,000-B)] Less: Bonus 280,150
B = .10(4,400,000-B-1,408,000+.32B) Tax 1,318,352
B= 440,000-.10B-140,800 + .032B) 1,598,502
B+.10B-.032B = 440,000-140,800 Income after bonus and tax 2,801,498
1.068B = 299,200 Bonus Rate 10%
B = 299,200/1.068 Bonus 280,150
B = 280,150

T = .32(4,400,000 - 280,150)
T = 1,318,352

d. After tax and before bonus

B = .10(4,400,000 - T) Proof:
T = .32(4,400,000 - B) Income before bonus and tax 4,400,000
B = .10[4,400,000 - .32(4,400,000 - B)] Tax (4,400,000 - 309,091) x 32% 1,309,091
B = .10(4,400,000 - 1,408,000 + .32B) Income after tax but before bonus 3,090,909
B = 440,000 - 140,800 +.032B Bonus Rate 10%
B - .032B = 440,000 - 140,800 309,091
.968B = 299,200
B = 299,200/.968
B = 309,091
L. Deferred Revenue
Deferred revenue or unearned revenue is income already received but not yet earned. Deferred
revenue maybe realized within one year or in more than one year from the end of the reporting period.

If the deferred revenue is realizable within one year, it is current liability, if more than one year it is
classifies as noncurrent liability.

Typical examples: unearned interest income, unearned rental income, unearned subscription revenue.

Proforma entries:

1. To record the receipts of revenue in advance:

Cash xx
Unearned Revenue xx

2. To recognize the revenue earned:

Unearned revenue xx
Revenue xx

Illustration:

An entity sells equipment service contracts agreeing to service equipment for 2-year period. Cash
receipts from contracts are credited to unearned service revenue and service contracts costs are
charged to service contract expense.

Revenue from service contracts are recognized as earned over the service period of the contracts.
The following transactions are made for the first year:

Cash receipts from service contract sold $ 1,000,000

Service contract cost paid 500,000
Service contract revenue recognized 800,000

Journal entries for the first year

1. To record the cash receipts from service contract sold

Cash $ 1,000,000
Unearned service revenue $ 1,000,000

2. To record the contract cost paid.

Service contract expense 500,000

Cash 500,000

3. To record the service contract revenue recognized

Unearned service revenue 800,000

Service contract revenue 800,000
 to assume that

within the January

ember 31, 2018.

2018, and the

mber 31, 2018.
1 LEARNING CHECK
1. Define liabilities.

2. Explain the measurement of current and noncurrent liabilities.

3. Define current and noncurrent liabilities.

4. What is a premium?

5. Explain briefly the accounting for the acquisition of premiums and

recognition of estimated premium liability.

6. Explain warranty.

7. Explain the accrual and expense as incurred approach of accounting

for warranty.

8. Explain gift certificates.

9. What are refundable deposits?

10. What is a deferred revenue?

 1 problems
Problem 1-1
During 2017, Day Company sold 500,000 boxes of cake mix under a new sales promotional program. Each box
contains one coupon, which entitles the customer to a baking pan upon remittance of $40, Day pays $50 for the
pan and $5 for handling and shipping. Day estimates that 80% of the coupons will be redeemed, even though
only 300,000 coupons had been processed during 2017.

Required:
What amount should Day Company report as a liability for unredeemed coupons at December 31, 2017?

Problem 1-2
Bare Company includes one coupon in each box of laundry soap it sells. A towel is offered as a premium
to customers who send in 10 coupons and a remittance of $20. Data for the premium offer are:
2017 2018

Boxes of soap sold 500,000 800,000

Number of towels purchased ($100 per towel) 20,000 25,000
Coupons redeemed 140,000 200,000

Bare Company's experience indicates that only 30% of the coupons will be redeemed.

Required:
How much is the estimated liability for premiums on December 31, 2018?

Problem 1-3
LaSalle Company includes one coupon in each package of cereal it sells. A crystal bowl is offered as
a premium to customers who send in 10 coupons. Data for the premium offer are:

2017 2018
Packages of cereal sold 500,000 800,000
Number of crystal bowls purchased at $40 per bowl 30,000 60,000
Number of crystal bowls distributed as premium 20,000 50,000
Number of crystal bowls to be distributed as premium
next period 5,000 3,000

Required:
How much premium expense should LaSalle Company report in its 2018 income statement?

Problem 1-4
Bold Company estimates its annual warranty expense at 2% of annual net sales. The following
data are available:
Net sales $ 4,000,000
Warranty liability:
December 31, 2017 60,000 credit
Warranty payments during 2018 50,000 debit

Required:
How much should be the warranty liability on December 31, 2018 after recording the 2014 warranty
expense?
Problem 1-5
During 2017, Roxy Company introduced a new product carrying a two-year warranty against defects. The
estimated warranty costs related to dollar sales are 2% within 12 months following sale and 4% in the
second 12 months following sale. Sales and actual warranty expenditures for the years ended December 31,
2017 and 2018 are as follows:
Actual warranty
Sales Expenditures

2017 $ 6,000,000 $ 90,000

2018 10,000,000 300,000
$ 16,000,000 $ 390,000

Required:
At December 31, 2018, how much should Roxy Company report as estimated warranty liability?

Problem 1-6
Regal Department Store sells gift certificates, redeemable for store merchandise, that expire one year after
issuance. Regal has the following information pertaining to its gift certificate sales and redemptions:

Unredeemed at January 1, 2017 $ 750,000

2017 sales 2,500,000
2017 redemptions of prior year sales 250,000
2017 redemptions of current year sales 1,750,000

Regal's experience indicates that 10% of gift certificates sold will not be redeemed.

Required:
In its December 31, 2017 statement of financial position, what amount should Regal Department Store
report as unearned revenue?

Problem 1-7
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
Company accounts for the containers not returned within the time limit as being retired by sale at the deposit
amount. Information for 2017 is as follows:

Container deposits at December 31, 2016 from deliveries in:

2015 150,000
2016 430,000 580,000
Deposits for containers delivered in 2017 780,000
Deposits for containers returned in 2017 from deliveries:
2015 90,000
2016 250,000
2017 286,000 626,000

Required:
How much is the liability for deposits on returnable containers that should be reported in Marr Company's
December 31, 2017 statement of financial position?

Problem 1-8
Greene Company sells office equipment service contracts agreeing to service equipment for a two-year period.
Cash receipts from contracts are credited to unearned service contract revenue and service contract costs are
charged to service contract expense as incurred. Revenue from service contracts is recognized as earned over
the lives of the contracts. Additional information for the year ended December 31, 2017 is as follows:
 Unearned service contract revenue at January 1 $ 600,000
Cash receipts from service contract sold 980,000
Service contract revenue recognized 860,000
Service contract expense 520,000

Required:
What amount should Greene report as unearned service contract revenue at December 31, 2017?

Problem 1-9
Hart Company sells subscription to a specialized directory that is published semiannually and shipped to
subscribers on April 1 and October 15. Subscriptions received after the March 31 and September 30 cut-off
dates are held for the next publications. Cash from subscribers is received evenly during the year and is credited
to deferred revenue from subscriptions. Data relating to 2017 are as follows:

Deferred revenue from subscriptions-January 1 $ 1,500,000

Cash receipts from subscribers 7,200,000

Required:
In its December 31, 2017 statement of financial position, what should Hart company report as deferred
revenue from subscription?

Problem 1-10
Information below were taken from the books and records of Easy Company as of December 31, 2017:

Notes payable: arising from purchases of merchandise, $60,000; arising from loans from banks, $15,000;
on which marketable securities valued at $20,000 have been pledged as security; arising
from advances by officers; $18,000.
Accounts payable: arising from purchases of merchandise, $70,000.
Cash balance with First Bank, $21,000; Bank overdraft with Second Bank, $12,000.

Dividends on preferred stock in arrears, $30,000.

Cash dividends payable on common stock, $4,500.

Withholding tax payable, $5,000.

Serial bonds, $150,000, payable in semi-annual installments of $15,000 due June 30 and December 31 of
each year.

Advances from customers, $13,000.

Estimated warranties expense on goods sold, $6,000.

Estimated damages on breach of contract, $7,000.
Accrued salaries payable, $9,500.
Gift certificates sold to customers not yet redeemed, $10,000.

Required:
Prepare the current liabilities section of the statement of financial position for Easy Company on
December 31, 2017.