Current Liabilities and Contingencies
Module 1 — Payables and Accrued Liabilities
Liabilities Defined
Under ASC 405 and the FASB Conceptual Framework, a liability is a present obligation arising from past events whose settlement requires a probable future sacrifice of economic benefits. Three essential characteristics define a liability:
- A present obligation to transfer assets or provide services
- The obligation is unavoidable — it results from a past transaction or event
- The transaction or event creating the obligation has already occurred
On the CPA exam, look for all three characteristics: (1) a present obligation, (2) arising from a past transaction, that (3) will result in a probable future sacrifice of economic benefits. If any element is missing, no liability exists.
Current vs. Non-Current Classification
A liability is classified as current if it is expected to be settled within one year or the operating cycle, whichever is longer. All other obligations are classified as non-current.
| Classification | Criteria | Examples |
|---|---|---|
| Current | Due within 1 year or operating cycle | Accounts payable, accrued wages, current portion of long-term debt |
| Non-current | Due beyond 1 year or operating cycle | Bonds payable, long-term notes, lease obligations |
If a company violates a long-term debt covenant at the balance sheet date and the lender has not waived the violation before the financial statements are issued, the entire long-term debt must be reclassified as current — even if the lender grants a waiver afterward.
Trade Accounts Payable
Trade accounts payable arise from purchasing goods or services on credit. When a vendor offers cash discount terms (e.g., 2/10, n/30), the buyer may record the payable using the gross method or the net method.
- Gross Method
- Net Method
Under the gross method, the payable is initially recorded at the full invoice price. The discount is recognized only if payment is made within the discount period.
Bear Co. purchases inventory for $50,000 with terms 2/10, n/30:
At purchase:
If paid within 10 days (discount taken):
If paid after 10 days (discount lapsed):
Under the net method, the payable is initially recorded at the net amount (invoice less discount). If the company fails to pay within the discount window, the extra cost is recorded as purchase discounts lost — a financing expense.
Bear Co. purchases inventory for $50,000 with terms 2/10, n/30:
At purchase (recorded net of 2% discount):
If paid within 10 days:
If paid after 10 days (discount lost):
:::tip Exam Tip
The net method is considered theoretically superior because it treats lost discounts as a financing cost, which more accurately reflects the economic reality. However, the gross method is more common in practice.
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Trade Notes Payable
A trade note payable is a formal written promise to pay a specified amount on a definite date. Unlike accounts payable, notes payable carry an explicit stated interest rate and a defined maturity.
Gies Co. issues a 6-month, 9%, $80,000 note payable to a supplier on October 1:
At December 31, Gies Co. accrues 3 months of interest:
At maturity (April 1), Gies Co. pays the note plus the remaining 3 months of interest:
Interest Payable Accruals
Interest payable must be accrued at each reporting date for any outstanding obligation. The general formula is:
Even when interest is paid semiannually or annually, the company must accrue interest from the last payment date through the balance sheet date under the matching principle.
Current Portion of Long-Term Debt
The portion of any long-term obligation that is due within the next 12 months must be reclassified as a current liability on the balance sheet.
MAS Inc. has a $300,000 term loan requiring annual principal payments of $60,000. At year-end, the balance sheet presentation is:
| Line Item | Amount |
|---|---|
| Current portion of long-term debt | $60,000 |
| Long-term debt (net of current portion) | $240,000 |
:::tip Exam Tip
An exception exists for short-term obligations expected to be refinanced on a long-term basis. If the company has the intent and ability to refinance (demonstrated by a refinancing agreement or actual refinancing before the statements are issued), the obligation may remain classified as non-current.
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Accrued Liabilities
Accrued liabilities represent expenses that have been incurred but not yet paid. Common accruals include wages, utilities, and rent.
BIF Partners has a biweekly payroll of $140,000. The pay period ends on Friday, January 3, but the fiscal year ends on Tuesday, December 31. Three of the ten working days in the pay period fall in the old year:
When the payroll is paid on January 3:
Taxes Payable
Companies accrue several categories of taxes. Each is recorded as a current liability until remitted.
Property Taxes
Property taxes are typically assessed by local governments for the fiscal year. They should be accrued ratably over the fiscal year to which they relate.
Kingfisher Industries receives a $24,000 property tax assessment for the calendar year. Monthly accrual:
Sales Taxes
Sales taxes collected from customers are held in trust and are never revenue to the seller — they are a liability from the moment of collection.
Illini Entertainment collects $5,300 from a customer on a $5,000 sale with 6% sales tax:
Income Taxes
Estimated income tax liabilities are accrued based on pretax income adjusted for permanent and temporary differences. This topic is covered in depth in the income taxes chapter, but the basic current liability entry is:
Payroll Taxes and Deductions
Payroll accounting requires careful distinction between employer payroll taxes and employee withholdings.
| Category | Paid By | Examples |
|---|---|---|
| Employee withholdings | Deducted from employee pay | Federal/state income tax, employee FICA, health insurance premiums |
| Employer taxes | Additional cost to employer | Employer FICA match, FUTA, SUTA |
Illini Security has monthly gross payroll of $200,000. Withholdings and employer taxes are:
| Item | Employee Portion | Employer Portion |
|---|---|---|
| FICA (Social Security 6.2% + Medicare 1.45%) | $15,300 | $15,300 |
| Federal income tax withheld | $30,000 | — |
| State income tax withheld | $8,000 | — |
| FUTA (0.6%) | — | $1,200 |
| SUTA (2.0%) | — | $4,000 |
Record gross payroll and employee withholdings:
Record employer payroll taxes:
Employee withholdings are not an expense to the employer — they are part of gross wages already expensed. The employer simply acts as an agent to remit these amounts to the government. Only the employer's matching share of FICA, FUTA, and SUTA creates additional payroll tax expense.
Compensated Absences (Vacation and Sick Pay)
Under ASC 710-10, a liability for compensated absences (vacation, sick leave) is accrued when all four conditions are met:
- The obligation relates to services already rendered
- The rights vest or accumulate
- Payment is probable
- The amount is reasonably estimable
- Vested rights: The employer must pay even if the employee terminates.
- Accumulated rights: Unused days carry forward to future periods.
- Sick pay that accumulates but does not vest need not be accrued (optional accrual is permitted).
Bear Co. grants employees 10 vacation days per year that vest on December 31. At year-end, 50 employees have earned but unused vacation worth an average of $240 per day:
Self-Insurance
Some companies choose to self-insure rather than purchase insurance from a third party. Under GAAP, a company cannot accrue a liability for self-insured risks before a loss occurs. The rationale is that no past event has given rise to a present obligation — the company is simply assuming future risk.
A common exam trap: self-insurance is not a recognized liability until an actual loss event occurs. You cannot accrue for hurricanes, lawsuits, or equipment breakdowns that have not yet happened, regardless of how probable they seem.
Once a loss event occurs (e.g., a fire destroys self-insured inventory), the company records the loss:
Exit or Disposal Activities (ASC 420)
Under ASC 420, costs associated with an exit or disposal activity are recognized as a liability when incurred — not when the company commits to an exit plan.
Key Cost Categories
| Cost Type | Recognition Point |
|---|---|
| Involuntary termination benefits (one-time) | When the plan is communicated to employees and they are not required to render future service |
| Contract termination costs | At the cease-use date (when the company stops using the right conveyed by the contract) |
| Other associated costs (relocation, consolidation) | When incurred |
MAS Inc. announces a plant closure on November 15 and communicates a one-time termination package of $500,000 to affected employees who will be terminated on December 31. No future service is required:
MAS Inc. also has a non-cancelable operating lease on the plant with 24 months remaining at $10,000/month. The cease-use date is December 31. At the cease-use date, the remaining obligation (net of estimated sublease rentals) is recognized:
Under ASC 420, if termination benefits require employees to render service beyond a minimum retention period (more than 60 days), the cost is recognized ratably over the future service period rather than immediately.
Asset Retirement Obligations (ASC 410-20)
An asset retirement obligation (ARO) is a legal obligation to dismantle, remove, or remediate a long-lived asset upon retirement. The obligation is recognized at fair value when incurred, with a corresponding increase to the carrying amount of the related asset (called the asset retirement cost, or ARC).
Initial Recognition
The ARO is measured at the present value of the estimated future retirement cost:
Kingfisher Industries installs an offshore oil platform on January 1, Year 1. The estimated removal cost in 20 years is $5,000,000, and the credit-adjusted risk-free rate is 6%:
Subsequent Measurement
After initial recognition, two things happen each period:
| Item | Treatment |
|---|---|
| ARO liability | Increases via accretion expense (interest on the growing obligation) |
| ARC (asset) | Decreases via depreciation over the asset's useful life |
Year 1 accretion expense:
Year 1 depreciation of ARC (straight-line over 20 years):
:::tip Exam Tip
Over time, the ARO liability grows via accretion until it reaches the full estimated removal cost at the end of the asset's useful life. The ARC component of the asset is fully depreciated over the same period. When the asset is retired, any difference between the ARO liability and the actual settlement cost is a gain or loss on settlement.
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Module 2 — Contingencies and Commitments
Contingencies Defined
A contingency is an existing condition, situation, or set of circumstances involving uncertainty about a possible gain or loss that will be resolved when one or more future events occur or fail to occur (ASC 450).
Key distinction: the condition already exists at the balance sheet date — only the outcome is uncertain.
Three Likelihood Categories
The accounting treatment for contingencies depends on the likelihood of the future event:
| Likelihood | Definition | Loss Treatment | Gain Treatment |
|---|---|---|---|
| Probable | Likely to occur | Accrue if estimable; disclose | Disclose only — never accrue |
| Reasonably possible | More than remote but less than probable | Disclose only | Disclose only |
| Remote | Slight chance of occurring | Generally ignore | Ignore |
Gain contingencies are never accrued — doing so would recognize revenue before it is realized. Even if a gain is deemed probable, the company may only disclose it in the notes. This is an application of conservatism.
Loss Contingencies — Accrual and Disclosure
A loss contingency is accrued (recognized as a liability and expense) when both conditions are met:
- It is probable that a liability has been incurred as of the balance sheet date
- The amount of the loss can be reasonably estimated
If only one condition is met, the contingency is disclosed in the notes but not accrued.
When a Range of Estimates Exists
| Scenario | Amount to Accrue |
|---|---|
| Single best estimate within the range | The best estimate |
| No best estimate identifiable | The minimum of the range |
Under IFRS (IAS 37), when no best estimate exists within a range, the midpoint is accrued. Under U.S. GAAP, the minimum is accrued. This is a common exam comparison.
Example — Lawsuit
BIF Partners is the defendant in a lawsuit as of December 31, Year 1. Legal counsel advises that a loss is probable, and estimates the loss between $200,000 and $500,000 with no amount more likely than another.
Under U.S. GAAP, accrue the minimum:
BIF Partners must also disclose in the notes the nature of the lawsuit and the possible additional exposure of up to $300,000 above the accrued amount.
Example — Reasonably Possible
Illini Entertainment is involved in patent infringement litigation. Legal counsel advises a loss is reasonably possible in the range of $100,000 to $400,000.
- No journal entry is recorded
- The nature of the contingency and the range of possible loss are disclosed in the notes
Example — Remote
Bear Co. is named in a frivolous lawsuit. Legal counsel deems the likelihood of loss as remote.
- No journal entry and generally no disclosure required
Exception for remote contingencies: Guarantees of the indebtedness of others must be disclosed even when the likelihood of loss is remote. This includes loan guarantees and standby letters of credit.
Gain Contingencies
Gain contingencies are subject to a stricter standard than loss contingencies:
| Likelihood | Treatment |
|---|---|
| Probable | Disclose in notes — do not accrue |
| Reasonably possible | Disclose in notes |
| Remote | No disclosure required |
Gies Co. files a lawsuit against a competitor for patent infringement and expects a favorable outcome. Even though legal counsel considers a gain probable, Gies Co. may only disclose the expected gain in the notes:
"The Company is the plaintiff in a patent infringement action. While the outcome cannot be determined with certainty, management believes a favorable resolution is probable."
The gain is recognized only when realized — typically when a court judgment is rendered or a settlement is finalized.
Premiums and Warranties
Product warranties and premium offers are accounted for as loss contingencies under ASC 450 because the obligation arises from a past event (the sale), a loss is probable, and the amount can be reasonably estimated.
Warranty Expense Accrual
- Expense Warranty (Accrual)
- Sales Warranty (Deferred Revenue)
Under the expense warranty approach (also called the accrual approach), the estimated warranty cost is recognized as an expense in the same period as the sale (matching principle).
Kingfisher Industries sells 1,000 units at $500 each during Year 1. Historical data indicates that 5% of units will require warranty service at an average cost of $60 per unit:
During Year 2, Kingfisher spends $2,400 on actual warranty repairs:
When a warranty is sold separately (an extended warranty), the revenue is deferred and recognized over the warranty period because it represents a separate performance obligation under ASC 606.
Illini Entertainment sells a 2-year extended warranty for $600:
Revenue recognized at the end of Year 1:
Actual warranty costs incurred in Year 1 are expensed as incurred:
Premium Offers
Premium offers (e.g., "send in 3 box tops and receive a free toy") create a liability similar to a warranty. The company estimates how many premiums will be redeemed and accrues accordingly.
Bear Co. sells cereal and offers a toy (cost $2 each) for every 5 box tops returned. During Year 1, Bear Co. sells 100,000 boxes and estimates that 60% of box tops will be redeemed:
Bear Co. purchases 15,000 toys and distributes 8,000 during Year 1:
Purchase of premiums inventory:
Premiums distributed (8,000 toys × $2):
Year-end accrual for remaining expected redemptions (12,000 − 8,000 = 4,000 toys × $2):
Summary — Decision Framework for Contingencies
The following decision tree summarizes the accounting treatment for loss contingencies:
:::tip Final Exam Reminders
- Losses: Probable + estimable → accrue. Range with no best estimate → accrue minimum (GAAP) or midpoint (IFRS).
- Gains: Never accrue — disclose only when probable or reasonably possible.
- Warranties: Accrue at point of sale using historical estimates (matching principle).
- AROs: Recognized at present value; accrete the liability and depreciate the ARC each period.
- Exit activities: Recognize when incurred, not when the plan is approved.
- Self-insurance: No accrual until an actual loss event occurs.
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