UNIT B

Accounting for Current Liabilities

Outline:

1. Premium and warranty liability

2. Accrued liabilities and deferred revenues

3. Provision and contingent liabilities

Objectives:

The student should be able to:

 Identify and apply accounting principles and standards in solving problems related to
premium liability and warranty liability, accrued liabilities and deferred revenue and
provision and contingent liability
PREMIUM, WARRANTY LIABILITY AND OTHER CURRENT LIABILITIES
PREMIUM
Premiums are articles of value such as toys, dishes, and other goods given to customers as a result
of past sales or sales promotion activities. These are offered to enhance sales and are exchanged with
the company’s product labels, box tops, wrappers and coupons presented by the customers.
When merchandise are sold, an accounting liability for future distribution of the premiums arises
and should be recognized. Following are sample transactions involving premiums.
Illustration:
A manufacturing company sells its product at P450 per unit. To enhance sales, the company
offered to give customers one kettle for every 5 wrappers returned plus a remittance of P15. A kettle
costs P75, and it is estimated that 60% of the wrappers will be redeemed.
For this promotion, the company purchased 2,000 kettles. Sales during the year was reported at
P4,500,000 (10,000 units) and there were 4,000 wrappers redeemed.
Journal Entries:
 To record sales
Cash P4,500,000
Sales P4,500,000

 To record purchase of premiums

Premiums – kettles 150,000
Cash 150,000

 To record 4,000 wrappers redeemed

Cash (4,000/5 = 800 x P15) 12,000
Premium expense (800 x P60) 48,000
Premiums – kettles (800 x P75) 60,000

 Outstanding premiums at the end of the year

Premium expense 24,000
Estimated premium liability 24,000

Computation:
Wrappers to be redeemed (4,500,000/75 x 60%) 6,000
Less: Wrappers redeemed 4,000
Balance 2,000
Divide by: No. of Wrappers per premium 5
Premium for distribution 400
Estimated liability (400 x P60) P24,000

Note: The kettles on hand at the end of the year amounting to P90,000 (150,000-60,000) shall
be presented as current assets and estimated premium liability of P24,000 as current liability
CASH REBATES
Companies may opt to offer cash rebates as part of its sales promotion campaign. In this program,
customers are required to present or send in proof of purchase such as cash register receipts, bar codes,
rebate coupons, etc. In this case, the estimated amount of cash rebate should be recognized at the end
of the accounting period

Illustration:
Paul Company offers a cash rebate of P10 on each baking pan sold during 2020. Customers get one coupon
for each baking purchased which must be presented when claiming the rebate. Based on company
experience, only 20% of customers surrender coupons for rebate.

During 2020, 100,000 baking pans were sold at P100 per unit and 8,500 coupons were redeemed.

Required: Prepare journal entries and determine the amount of liability to be reported on December 31,
2020.

Journal Entries:

 To record sales
Cash P10,000,000
Sales P10,000,000

 To recognize the estimated cash rebates

Rebate expense 200,000
Estimated rebate liability 200,000

 To record 8,500 coupons redeemed

Estimated rebate liability 85,000
Cash 85,000

WARRANTY LIABILITY

Warranty is a legally binding assurance that a product is, among other things
 Fit for use as represented
 Free from defective material and workmanship
 Meets statutory and/or other specifications

A warranty describes the conditions under, and period during, which the producer or vendor will repair,
replace, or otherwise compensate for, the defective item without cost to the buyer or user. Often it also
delineates the rights and obligations of both parties in case of a claim or dispute.
Warranty is recorded at the time of sale based on best estimate. Estimate is reviewed at a certain date
and difference between estimate and actual cost is accounted as change in accounting estimate to be
treated currently and prospectively.
Pro-forma journal entries for transactions involving warranty under accrual approach

1. When products with warranties are sold

Warranties expense XX
Estimated warranties liability XX

2. Disbursement for warranty

Estimated warranties liability XX
Cash XX

3. Actual cost exceeds estimate

Warranties Expense XX
Cash XX
4. Actual cost is less than estimate
Estimated warranties liability XX
Warranties expense XX

Illustration: Provision - Warranties

George Company sells motorcycles that carry a two-year warranty against manufacturer's defects. Based
on entity's experience, warranty costs are estimated at P5,000 per unit. During the current year, the
entity sold 1,000 units and paid warranty costs of P3.400,000.

Required: Determine the amount of liability to be reported.

SOLUTION: Warranties Liability

- Balance, Beg.
Cost incurred for
warranties P 3,400,000 5,000,000 Warranties Expense
P 3,400,000 P 5,000,000
Balance, End 1,600,000
P 5,000,000 P 5,000,000

*(P5,000x1,000 units)

Illustration: Warranty - Sales are Made Evenly

Carmelo Co. sells computer to various customers. Carmelo Co. has been offering a special service
warranty on computer units it sold. With the purchase of the computer unit, the customer has the right
to purchase 3: year service contract for additional amount of P1,000. Data concerning sales of computer
and warranty contract follow:

2017 2018
Computer sales in units 1,000 1,200
Sales price per unit P12,000 P14,000
800 900
 Number of service contracts
sold P30,000 50,000
Expense relating to computer
warranties

Carmelo Co. has estimated based on the available past records that the pattern of repairs has been.
44% Year of Sale
38% 1st year after sale
18% 2nd year after sale

Sales of the contracts are made evenly during the year.

Required:
1) How much unearned service contract would be earned in the year 2018?
2) How much profit on service contract would be recognized in year 2018?
3) How much is unearned service contract on December 31, 2018?

SOLUTION:
Pattern of Realized Revenues:

2017 SALES
From sales in 2017 2018 2019 2020 Total
1st (44%x ½) 0.22 0.22 0.44
2nd (38%x½) 0.19 0.19 0.38
3rd (18% x½) 0.09 0.09 0.18
Total 0.22 0.41 0.28 0.09 1

2018 SALES
From sales in 2018 2019 2020 2021 Total
1st (44%x ½) 0.22 0.22 0.44
2nd (38%x½) 0.19 0.19 0.38
3rd (18% x½) 0.09 0.09 0.18
Total 0.22 0.41 0.28 0.09 1

Requirement No. 1
Warranty Sales in 2017 earned in 2018 (41% x 800 x P1,000) 328,000
Warranty Sales in 2018 earned in 2018 (22% x 900 x P1,000) 198,000
Total warranty sales revenue earned in 2018 526,000

Notes:
 The 41% represents the realized revenue in 2018 from 2017 Sales.
 The 22% represents the realized revenue in 2018 from 2018 Sales.

Requirement No. 2
Total warranty sales revenue earned in 2018 (see No. 1) P526,000
Expenses relating to computer warranties 50,000
Profits from sales warranty P476,000
Requirement No. 3
Unearned sales warranty from 2017 [(28% + 9% x 300 x P1,000)] P296,000
Unearned sales warranty from 2018 (100%-22%) x 900 x P1,000)] 702,000
Total unearned sales warranty P998,000

Notes:
 The 28% and 9% represent the unrealized revenues in 2018 from 2017 Sales.
 The 22% represents the realized revenue in 2018 from 2018 Sales. So 100% minus 22% realized
is equal to 78% unrealized revenue in 2018 from 2018 Sales.

PROVISION AND CONTINGENT LIABILITY

A provision is a liability of uncertain amount or uncertain timing provisions. Provisions are

actually estimated liability.

A provision is recognized when:

a. an entity has a present obligation (legal or constructive) as a result of past event.
b. it is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; and
c. a reliable estimate can be made of the amount of the obligation.

If these conditions are not met, no provision shall be recognized.

Pro-forma journal entry:

To record the recognition of a provision:
Expense XX
Estimated Liability XX

A contingent liability is:

a. a possible obligation that arises from past events and 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 entity; or

b. a present obligation that arises from past events but is not recognized because:
 it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
 the amount of the obligation cannot be measured with sufficient reliability.

Relationship between provision and contingent liability

In general sense, all provisions are contingent because they are uncertain in timing or amount.
The term “contingent” is used for items that are not recognized because their existence will be
confirmed by occurrence or non-occurrence of one or more uncertain future events not within the
control of the entity.
The “contingent liability” is used for liabilities that do not meet the recognition criteria.
Provision vs. contingent liability
Provision Contingent Liability
 A present obligation  A possible obligation
 Both probable and reliably  A present obligation which is either
measurable probable or reliably measurable but not
 Recognized as a regular liability in both.
the financial statements  Disclosed in the notes to financial
statements and not recognized in the
financial statements.

Likelihood of occurrence Meaning

Probable The future event is more likely than not to occur. (i.e. the probability
that the event will occur is greater that the probability that it will not)
Reasonably possible The future event is less likely to occur.
Remote The future event is least likely to occur.

Summary of Accounting Treatments for Contingencies

Level of uncertainty Reliably Accounting Treatment Remarks

Measurable Accrue Disclose Ignore

Loss Contingencies
Treated as
Probable Yes X Provision
Probable No X Categorized as
Possible Yes/No X contingent
Remote Yes/No X liabilities

Gain Contingencies
Treated as an
Virtually Certain Yes X asset
Virtually Certain No X Categorized as
Probable Yes/No X contingent assets
Possible/Remote Yes/No X

Basic rule: No contingent items shall be recognized on the face of financial statements

Measurement of provision

The amount recognized as a provision shall be the best estimate of the expenditure required to settle
the present obligation at the end of the reporting period. Best estimate is determined as follows:
 a) The estimates of outcome and financial effect are determined by the judgment of the
management of the entity, supplemented by experience of similar transactions and, in some
cases, reports from independent experts.

b) Where the provision being measured involves a large population of items, the obligation is
estimated by weighting all possible outcomes by their associated probabilities. The name for this
statistical method of estimation is ‘expected value'.

c) Where there is a continuous range of possible outcomes, and each point in that range is as likely
as any other, the mid-point of the range is used.

Consideration in determining best estimate

1. Risks and uncertainties that surround the underlying events

2. Future events
a. forecast reasonable changes in applying existing technology
b. ignore possible gains on sale of assets
c. consider changes in legislation only if virtually certain to be enacted

3. Discounted present value using a pre-tax discount rate that reflect the current market
assessments of the time value of money and the risks specific to the liability

4. Reimbursement by another party

If some or all of the expenditure required to settle a provision is expected to be reimbursed by
another party, the reimbursement should be recognized as a separate asset provided it is virtually
certain that reimbursement will be received if the entity settles the obligation.

The amount recognized as an asset should not exceed the amount of the provision and it should
not be treated as a reduction of the required provision

5. Gains on expected disposal of assets

An entity recognizes gains on expected disposals of assets at the time of disposition of assets.

6. Presence of onerous contract

If an entity has an onerous contract, the present obligation under the contract shall be recognized
and measured as a provision.

7. Remeasurement of provisions
The following shall be performed when measuring provisions subsequent to initial recognition.
a) Review and adjust provisions at each reporting date.
b) If an outflow no longer probable, provision is reversed.

8. Use of provisions
If it is no longer probable that an outflow of resources will be required to settle the obligation,
the provision should be reversed.
Examples of Provisions
Circumstances
Restructuring by sale of
an operation
Restructuring by closure
or reorganization
Warranty
Land Contamination
Customer Refunds
Offshore oil rig must be
removed and sea bed
restored
Abandoned leasehold,
four years to run, no
reletting possible
Onerous (loss-making)
contract
Self-insured restaurant,
people were poisoned,
lawsuits are expected
but none has been field
yet
A chain of retail stores is
self-insured for fire loss.
CPA firm must staff
training for recent
change in tax law
Major overhaul repairs
Future operating losses
Recognized as a provision
Only when the entity is committed to a sale, i.e. there is a binding
sale agreement
Only when a detailed form plan is in place and the or reorganization
entity has started to implement the plan, or announced its main
features to those affected. A Board decision is insufficient
When an obligating event occurs (sale of product with a warranty
and probable warranty claims will be made)
A provision is recognized as contamination occurs for any legal
obligations of clean up, or for constructive obligations if the
company’s published policy is to clean up even if there is no legal
requirement to do so (past event is the contamination and public
expectation created by the company’s policy)
Recognize a provision if the entity's established policy is to give
refunds (past event is the sale of the product together with the
customer's expectation, at the time of purchase, that a refund would
be
available)
Recognize a provision for removal costs arising from the
construction of the oil rig as it is constructed, and add to the cost of
the asset Obligations arising from the production of oil are
recognized as the production occurs
A provision is recognized for the unavoidable lease payments.
Recognize a provision
Accrue a provision (the past event is the injury to customers)
No provision until a an actual fire (no past event)
No provision is recognized (there is no obligation to provide the
training, recognize a liability if and when the retraining occurs)
No obligation is recognized ( no obligation)
No provision is recognized ( no obligation)
Illustration: Best estimate

Anthony Company sells cars. In 2018, the entity sold 1,000 units before discovering a significant defect
in their construction. By December 31, 2018 two lawsuits had been filed against the entity. Below are
the estimates made by the entity's management and legal counsel:
 First lawsuit - the entity has a little chance of winning and is expected to be settled out of court
for P2,500,000 in 2018.
 Second lawsuit -The entity's legal counsel believes that it is likely that the entity will win. The
entity is being sued for P1,000,000.

Required: Determine the amount of liability to be accrued on December 31 2018 as a result of these
lawsuits.

SOLUTION:
Liability to be accrued P2,500,000
• In the first lawsuit, since the entity is expecting to settle out of court, the estimated settlement shall
be accrued in 2018.
• In the second lawsuit, since the level of uncertainty involved is only "likely", which is equivalent to
possible, no liability shall be recognized but disclosure in the note to financial statements shall be
made.

Illustration: Best estimate – Expected Value

Love Co. manufactures and sells motorcycle helmets. In 2018, the entity sold 1,000,000 units prior to the
discovery of a possible defect caused by malfunctioning factory equipment. The helmets were recalled
and will be repaired free of charge. Love is uncertain whether all helmets recalled will have the possible
defect. However, the following estimate was made by Love's management and was approved by the
board of directors.

Repair Cost Probability

P40,000,000 10%
30,000,000 20%
20,000,000 30%
10,000,000 40%
100%

Required: Determine the amount of liability to be accrued on December 31, 2018.

SOLUTION:
Repair Cost Probability Provision
P40,000,000 10% = P4,000,000
30,000,000 20% = 6,000,000
20,000,000 30% = 6,000,000
10,000,000 40% = 4,000,000
100% P20,000,000
Illustration: Best Estimate - Mid-Point

In 2018, a lawsuit was filed against Kyrie Co. for patent infringement. The plaintiff is claiming P5,000,000
in damages. Kyrie's legal counsel believes that it is probable that Kyrie will lose the lawsuit and pay
damages of not less than P2,000,000 but not more than P10,000,000. The probability of any amount
within the range is as likely as any other amount also within the range.

Required: Determine the amount of liability to be accrued on December 31, 2018 as a result of this
lawsuit.

SOLUTION: Liability to be accrued (P2,000,000 + P10,000,000)/2 P6,000,000

Illustration: Provision - Changes in Estimate

In 2016, Stephen Co. recognized provision for a probable loss on pending lawsuit of P10,000,000. The
lawsuit remains unsettled in 2017 necessitating a reassessment of the provision Stephen determined
that the probable loss on the pending law suit should be P14,000,000.

Required: Provide all necessary journal entries under the following independent assumptions.
1) The lawsuit was settled for P15,000,000 in 2018.
2) The lawsuit was settled for P12,750,000 in 2018.
3) Stephen won the lawsuit in 2018.

SOLUTION:
Entry to be made in 2016:
Loss on lawsuit P10,000,000
Estimated liability P10,000,000

Entry to be made in 2017:

Loss on lawsuit P4,000,000
Estimated liability P4,000,000

1) The lawsuit was settled for P15,000,000 in 2018.

Estimated liability 14,000,000
Loss on lawsuit 1,000,000
Cash P15,000,000

2) The lawsuit was settled for P12,750,000 in 2018.

Estimated liability 14,000,000
Cash 12,750,000
Gain on Settlement 1,250,000

3) Stephen won the lawsuit in 2018.

Estimated liability 14,000,000
Gain on Settlement 14,000,000

Note: Changes in estimate of provision are accounted prospectively

REFERENCES:

Milan, ZVD (2019), Intermediate Accounting 2. Baguio City: Bandolin Enterprises

Valix, C.T., Peralta, J.F., & Valix, C.A.M. (2019) Intermediate Accounting Vol 2. Manila: GIC Enterprises &
Co., Inc.
 REVIEW QUESTIONS

PROBLEM 1
To increase sales, Nowitzki Company inaugurated a promotional campaign on June 30, 2018. Nowitzki
placed a coupon redeemable for a premium in each box of cake sold at P200. A coffee mug costing P30
is offered as premium to customers who send in 5 coupons and a remittance of P10. The distribution
cost per premium is P5. Nowitzki estimated that only 80% of the coupons issued will be redeemed. For
the six months ended December 31, 2018, the following is available:

Boxes of cake sold 20,000

Premiums purchased 3,000
Coupons redeemed 10,000

What is the estimated liability for coupons on December 31, 2018?

PROBLEM 2
During 2017, Dirk Company introduced a new product carrying a two-year warranty against defects. The
estimated warranty cost related to peso sales are 4% within 12 months following sale and 6% in the
second 12 months following sale. Sales and actual warranty expenditures for the years ended December
31, 2017 and 2018 are as follows:

Sales Actual Expenditures

2017 P5,000,000 P150,000
2018 6,000,000 550,000

At December 31, 2018, what would be reported as estimated warranty liability?

PROBLEM 3
On April 1, 2018, Carter Company began offering a new product for sale under a one-year warranty. Of
the 5,000 units in inventory at April 1, 2018, 3,000 had been sold by June 30, 2018. Based on its
experience with similar products, the entity estimated that the average warranty cost per unit sold
would be P160. Actual warranty costs incurred from April 1 through June 30, 2018 were P140,000

On June 30, 2018, the amount to be reported as warranty liability is:

PROBLEM 4
On November 5, 2018, a Sheradez Company truck was in an accident with an auto driven by Joy. Sheradez
received notice on January 15, 2019, of a lawsuit for P4,000,000 damages for personal injuries suffered
by Joy. Sheradez's counsel believes it is probable that Joy will be awarded an estimated amount in the
range between P10,000 and P4,000,000, and no amount is a better estimate of potential liability than any
other amount. The accounting year ends on December 31 and the 2018 financial statements were issued
on March 31, 2019.

What amount of provision should Sheradez accrue at December 31, 2018?

PROBLEM 5
In September 2018, the lawyers of the current and former employees of Fisher Inc, filed a P3,000,000
class action lawsuit, alleging that exposure to radiation have caused significant medical problems. The
lawyer of Fisher is uncertain as to the outcome of the case. However, similar lawsuits against other firms
in the same industry have resulted in significant payments by the employer but there was no reliable
estimate as to the amount.

In Fisher's December 31, 2018 financial statements, which were issued on April 30, 2019, how much
liability should item be reported?

PROBLEM 6
In January 2018, Derick Co. gives a guarantee on a loan of Rose Corp. amounting to P3,000,000. During
the year, the financial condition of the Rose deteriorates and at year-end, Rose files a petition for
bankruptcy. In its year-end financial statements, Derick should
a. Not accrue and need not disclose the guarantee
b. Accrue and disclose the provision of P3,000,000
c. Accrue a provision for liability of P3,000,000
d. Disclose the possible loss of P3,000,000