UU IFA II Melaku K.

CHAPTER THREE
Current Liabilities, Provisions, and Contingencies
Current Liabilities
The question, “What is a liability?” is not easy to answer. For example, are preference shares a
liability or an ownership claim? The first reaction is to say that preference shares are in fact an
ownership claim, and companies should report them as part of equity. In fact, preference shares
have many elements of debt as well. The issuer (and in some cases the holder) often has the right
to call the shares within a specific period of time—making them similar to a repayment of
principal. The dividends on the preference shares are in many cases almost guaranteed (the
cumulative provision) — making them look like interest. As a result, preference shares are but
one of many financial instruments that are difficult to classify.
To help resolve some of these controversies, the IASB, as part of its Conceptual Framework,
defines a liability as a present obligation of the entity to transfer an economic resource as a result
of past events. In other words, a liability has three essential characteristics:
1. It is a present obligation.
2. It requires a transfer of economic resources (cash, goods, services).
3. It arises from past events.
To determine the appropriate classification of specific financial instruments, companies need
proper definitions of assets, liabilities, and equities. They often use the Conceptual Framework
definitions as the basis for resolving controversial classification issues. Because liabilities
involve future disbursements of assets or services, one of their most important features is the date
on which they are payable. A company must satisfy currently maturing obligations in the
ordinary course of business to continue operating. Liabilities with a more distant due date do not,
as a rule, represent a claim on the company’s current resources. They are therefore in a slightly
different category. This feature gives rise to the basic division of liabilities into (1) current
liabilities and (2) non-current liabilities. Recall that current assets are cash or other assets that
companies reasonably expect to convert into cash, sell, or consume in operations within a single
operating cycle or within a year (if completing more than one cycle each year). Similarly, a
current liability is reported if one of two conditions exists:
1. The liability is expected to be settled within its normal operating cycle; or
2. The liability is expected to be settled within 12 months after the reporting date.

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This definition has gained wide acceptance because it recognizes operating cycles of varying
lengths in different industries.
The operating cycle is the period of time elapsing between the acquisition of goods and services
involved in the manufacturing process and the final cash realization resulting from sales and
subsequent collections? Industries that manufacture products requiring an aging process, as well
as certain capital-intensive industries, have an operating cycle of considerably more than one
year. In these cases, companies classify operating items, such as accounts payable and accruals
for wages and other expenses, as current liabilities, even if they are due to be settled more than
12 months after the reporting period.
Here are some typical current liabilities:
1. Accounts payable. 6. Customer advances and deposits.
2. Notes payable. 7. Unearned revenues.
3. Current maturities of long-term debt. 8. Sales and value-added taxes payable.
4. Short-term obligations expected to be refinanced. 9. Income taxes payable.
5. Dividends payable. 10. Employee-related liabilities.
Accounts Payable
Accounts payable, or trade accounts payable, are balances owed to others for goods, supplies,
or services purchased on open account. Accounts payable arise because of the time lag between
the receipt of services or acquisition of title to assets and the payment for them. The terms of the
sale (e.g., 2/10, net 30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30
to 60 days.
Most companies record liabilities for purchases of goods upon receipt of the goods. If title has
passed to the purchaser before receipt of the goods, the company should record the transaction at
the time of title passage. A company must pay special attention to transactions occurring near the
end of one accounting period and at the beginning of the next. It needs to ascertain that the
record of goods received (the inventory) agrees with the liability (accounts payable), and that it
records both in the proper period.
Measuring the amount of an account payable poses no particular difficulty. The invoice received
from the creditor specifies the due date and the exact outlay in money that is necessary to settle
the account. The only calculation that may be necessary concerns the amount of cash discount.

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Notes Payable
Notes payable are written promises to pay a certain sum of money on a specified future date.
They may arise from purchases, financing, or other transactions. Some industries require notes
(often referred to as trade notes payable) as part of the sales/purchases transaction in lieu of the
normal extension of open account credit. Notes payable to banks or loan companies generally
arise from cash loans. Companies classify notes as short-term or long-term, depending on the
payment due date. Notes may also be interest-bearing or zero-interest-bearing.
Interest-Bearing Note Issued
Assume that Castle Bank agrees to lend br. 100,000 on March 1, 2022, to Landscape Co. if
Landscape signs a Br. 100,000, 6 percent, four-month note. Landscape records the cash received
on March 1 as follows.
March 1, 2022
Cash Br. 100,000
Notes Payable Br. 100,000
(To record issuance of 6%, 4-month note to Castle Bank)
If Landscape prepares financial statements semiannually, it makes the following adjusting entry
to recognize interest expense and interest payable of Br. 2,000 (Br. 100,000 × .06 × 4⁄12) at June
30, 2022.
June 30, 2022
Interest Expense Br. 2,000
Interest Payable Br. 2,000
(To accrue interest for 4 months on Castle Bank note)
If Landscape prepares financial statements monthly, its interest expense at the end of each month
is Br. 500 (Br. 100,000 × .06 × 1⁄12). At maturity (July 1, 2022), Landscape must pay the face
value of the note (Br. 100,000) plus Br. 2,000 interest (Br. 100,000 × .06 × 4⁄12). Landscape
records payment of the note and accrued interest as follows.
July 1, 2022
Notes Payable Br. 100,000
Interest Payable Br. 2,000
Cash Br. 102,000
(To record payment of Castle Bank interest-bearing note and accrued interest at maturity)

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Zero-Interest-Bearing Note Issued

A company may issue a zero-interest-bearing note instead of an interest-bearing note. A zero
interest bearing note does not explicitly state an interest rate on the face of the note. Interest is
still charged, however. At maturity, the borrower must pay back an amount greater than the cash
received at the issuance date. In other words, the borrower receives in cash the present value of
the note. The present value equals the face value of the note at maturity minus the interest or
discount charged by the lender for the term of the note.
To illustrate, assume that Landscape issues a Br. 102,000, four-month, zero-interest-bearing note
to Castle Bank on March 1, 2022. The present value of the note is Br. 100,000. Landscape
records this transaction as follows.
March 1, 2022
Cash Br. 100,000
Notes Payable Br. 100,000
(To record issuance of 4-month, zero-interest-bearing note to Castle Bank)
Landscape credits the Notes Payable account for the present value of the note, which is Br.
100,000. If Landscape prepares financial statements semiannually, it makes the following
adjusting entry to recognize the interest expense and the increase in the note payable of €2,000 at
June 30, 2022.
June 30, 2022
Interest Expense Br. 2,000
Notes Payable Br. 2,000
(To accrue interest for 4 months on Castle Bank note)
At maturity (July 1, 2022), Landscape must pay the face value of the note, as follows.
July 1, 2022
Notes Payable Br. 102,000
Cash Br. 102,000
(To record payment of Castle Bank zero-interest-bearing at maturity)
In this case, the amount of interest expense recorded and the total cash outlay are exactly the
same whether Landscape signed a loan agreement with a stated interest rate or used the zero-
interest-rate approach. This circumstance rarely happens, because often the borrower on an

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interest-bearing note will have to make monthly cash payments for interest during the term of the
note.
Current Maturities of Long-Term Debt
BKG Group reports as part of its current liabilities the portion of bonds, mortgage notes, and
other long-term indebtedness that matures within the next fiscal year. It categorizes this amount
as current maturities of long-term debt. Companies such as BKG exclude currently maturing
long-term debts from current liabilities if they are to be:
1. Refinanced, or retired from the proceeds of a new long-term debt issue (discussed in the next
section); or,
2. Converted into ordinary shares.
When only a part of a long-term debt is to be paid within the next 12 months, as in the case of
serial bonds that a company retires through a series of annual installments, a company reports
the maturing portion of long-term debt as a current liability and the remaining portion as a
long-term debt. However, a company should classify as current any liability that is due on
demand (callable by the creditor), or will be due on demand within one year (or operating cycle,
if longer). Liabilities often become callable by the creditor when there is a violation of the debt
agreement. For example, most debt agreements specify that a given level of equity to debt be
maintained, or specify that working capital be of a minimum amount. If the company violates an
agreement, it must classify the debt as current because it is a reasonable expectation that existing
working capital will be used to satisfy the debt.
To illustrate a breach of a covenant, assume that Gyro Company on November 1, 2022, has a
long-term note payable to Sanchez SA, which is due on April 1, 2024. Unfortunately, Gyro
breaches a covenant in the note, and the obligation becomes payable on demand. Gyro is
preparing its financial statements at December 31, 2022. Given the breach in the covenant, Gyro
must classify its obligation as current. However, Gyro can classify the liability as non-current if
Sanchez agrees before December 31, 2022, to provide a grace period for the breach of the
agreement. The grace period must end at least 12 months after December 31, 2022, to be
reported as a non-current liability. If the agreement is not finalized by December 31, 2022, Gyro
must classify the note payable as a current liability.

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Dividends Payable
A cash dividend payable is an amount owed by a company to its shareholders as a result of the
board of directors’ authorization (or in other cases, vote of shareholders). At the date of
declaration, the company assumes a liability that places the shareholders in the position of
creditors in the amount of dividends declared. Because companies always pay cash dividends
within one year of declaration (generally within three months), they classify them as current
liabilities.
On the other hand, companies do not recognize accumulated but undeclared dividends on
cumulative preference shares as a liability. Why? Because preference dividends in arrears are
not an obligation until the board of directors authorizes the payment. Nevertheless, companies
should disclose the amount of cumulative dividends unpaid in a note, or show it parenthetically
in the share capital section.
Preference dividends in arrears do represent a probable future economic sacrifice, but the
expected sacrifice does not result from a past transaction or past event. The sacrifice will result
from a future event (declaration by the board of directors). Note disclosure improves the
predictive value of the financial statements.
Dividends payable in the form of additional shares are not recognized as a liability. Such share
dividends do not require future outlays of assets or services. Companies generally report such
undistributed share dividends in the equity section because they represent retained earnings in
the process of transfer to share capital.

Customer Advances and Deposits

Current liabilities may include returnable cash deposits received from customers and
employees. Companies may receive deposits from customers to guarantee performance of a
contract or service or as guarantees to cover payment of expected future obligations. The
classification of these items as current or non-current liabilities depends on the time between the
date of the deposit and the termination of the relationship that required the deposit.

Unearned Revenues
How do companies account for unearned revenues that they receive before providing goods or
performing services?
1. When a company receives an advance payment, it debits Cash and credits a current liability
account identifying the source of the unearned revenue.
2. When a company recognizes revenue, it debits the unearned revenue account and credits a
revenue account.
The account Unearned Sales Revenue represents unearned revenue. Logo University reports it as
a
current liability in the statement of financial position because the school has a performance
obligation.

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Sales and Value-Added Taxes Payable

Most countries have a consumption tax. Consumption taxes are generally either a sales tax or a
value-added tax (VAT). The purpose of these taxes is to generate revenue for the government
similar to the company or personal income tax. These two taxes accomplish the same objective
—to tax the final consumer of the good or service. However, the two systems use different
methods to accomplish this objective.
Sales Taxes Payable
To illustrate the accounting for sales taxes, assume that Halo Supermarket sells loaves of bread
to consumers on a given day for Br. 2,400. Assuming a sales tax rate of 10 percent, Halo
Supermarket makes the following entry to record the sale.
Cash 2,640
Sales Revenue 2,400
Sales Taxes Payable 240
In this situation, Halo Supermarket records a liability to provide for taxes collected from
customers but not yet remitted to the appropriate tax authority. At the proper time, Halo
Supermarket remits the Br. 240 to the tax authority.
Sometimes, the sales tax collections credited to the liability account are not equal to the liability
as computed by the governmental formula. In such a case, companies make an adjustment of the
liability account by recognizing a gain or a loss on sales tax collections. Many companies do not
segregate the sales tax and the amount of the sale at the time of sale. Instead, the company credits
both amounts in total in the Sales Revenue account. Then, to reflect correctly the actual amount
of sales and the liability for sales taxes, the company debits the Sales Revenue account for the
amount of the sales taxes due the government on these sales and credits the Sales Taxes Payable
account for the same amount.
To illustrate, assume that the Sales Revenue account balance of Br. 150,000 includes sales taxes
of 4 percent. Thus, the amount recorded in the Sales Revenue account is comprised of the sales
amount plus sales tax of 4 percent of the sales amount. Sales therefore are Br. 144,230.77 (Br.
150,000 ÷ 1.04) and the sales tax liability is Br. 5,769.23 (Br. 144,230.77 × 0.04, or Br. 150,000
– Br. 144,230.77). The following entry records the amount due to the tax authority.
Sales Revenue 5,769.23
Sales Taxes Payable 5,769.23

Value-Added Taxes Payable

Value-added taxes (VAT) are used by tax authorities more than sales taxes (over 100 countries
require that companies collect a value-added tax). As indicated earlier, a value-added tax is a
consumption tax. This tax is placed on a product or service whenever value is added at a stage of
production and at final sale. A VAT is a cost to the end user, normally a private individual,
similar to a sales tax.
However, a VAT should not be confused with a sales tax. A sales tax is collected only once at
the consumer’s point of purchase. No one else in the production or supply chain is involved in
the collection of the tax. In a VAT taxation system, the VAT is collected every time a business
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purchases products from another business in the product’s supply chain. To illustrate, let’s return
to the Halo Supermarket example but now assume that a VAT is imposed rather than a sales tax.
To understand how a VAT works, we need to understand how the loaves of bread were made
ready for purchase. Here is what happened.
1. Hill Farms Wheat grows wheat and sells it to Sunshine Baking for Br. 1,000. Hill Farms
Wheat makes the following entry to record the sale, assuming the VAT is 10 percent.
Cash 1,100
Sales Revenue 1,000
Value-Added Taxes Payable 100
Hill Farms Wheat then remits the Br. 100 to the tax authority.
2. Sunshine Baking makes loaves of bread from this wheat and sells it to Halo Supermarket for
Br. 2,000. Sunshine Baking makes the following entry to record the sale, assuming the VAT is
10 percent.
Cash 2,200
Sales Revenue 2,000
Value-Added Taxes Payable 200
Sunshine Baking then remits €100 to the government, not €200. The reason: Sunshine Baking
has already paid Br. 100 to Hill Farms Wheat. At this point, the tax authority is only entitled to
Br. 100. Sunshine Baking receives a credit for the VAT paid to Hill Farms Wheat, which reduces
the VAT payable.
3. Halo Supermarket sells the loaves of bread to consumers for €2,400. Halo Supermarket makes
the following entry to record the sale, assuming the VAT is 10 percent.
Cash 2,640
Sales Revenue 2,400
Value-Added Taxes Payable 240
Halo Supermarket then sends only Br. 40 to the tax authority, because it deducts the Br. 200
VAT already paid to Sunshine Baking.

Income Taxes Payable

Most income tax varies in proportion to the amount of annual income. Using the best information
and advice available, a business must prepare an income tax return and compute the income
taxes payable resulting from the operations of the current period. Companies should classify as a
current liability the taxes payable on net income, as computed per the tax return. However, in
many countries proprietorships and partnerships are not taxable entities. Because the individual
proprietor and the members of a partnership are subject to personal income taxes on their share
of the business’s taxable income, income tax liabilities do not appear on the financial statements
of proprietorships and partnerships.
Most companies must make periodic tax payments throughout the year to the appropriate
government agency. These payments are based upon estimates of the total annual tax liability. As
the estimated total tax liability changes, the periodic payments also change. If, in a later year, the

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taxing authority assesses an additional tax on the income of an earlier year, the company should
credit Income Taxes Payable and charge the related debit to current operations.
Differences between taxable income under the tax laws and accounting income under IFRS
sometimes occur. Because of these differences, the amount of income taxes payable to the
government in any given year may differ substantially from income tax expense as reported on
the financial statements.
Employee-Related Liabilities
Companies also report as a current liability amounts owed to employees for salaries or wages at
the end of an accounting period. In addition, they often also report as current liabilities the
following items related to employee compensation.
1. Payroll deductions.
2. Compensated absences.
3. Bonuses.

Payroll Deductions
The most common types of payroll deductions are taxes, insurance premiums, employee savings,
and union dues. To the extent that a company has not remitted the amounts deducted to the
proper authority at the end of the accounting period, it should recognize them as current
liabilities.
Social Security Taxes
Most governments provide a level of social benefits (for retirement, unemployment, income,
disability, and medical benefits) to individuals and families. The benefits are generally funded
from taxes assessed on both the employer and the employees. These taxes are often referred to as
Social Security taxes or Social Welfare taxes. Employers collect the employee’s share of this
tax by deducting it from the employee’s gross pay, and remit it to the government along with
their share. The government often taxes both the employer and the employee at the same rate.
Companies should report the amount of unremitted employee and employer Social
Security tax on gross wages paid as a current liability.
Income Tax Withholding
Income tax laws generally require employers to withhold from each employee’s pay the
applicable income tax due on those wages. The employer computes the amount of income tax to
withhold according to a government-prescribed formula or withholding tax table. That amount
depends on the length of the pay period and each employee’s taxable wages, marital status, and
claimed dependents.

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