Chapter 9
Current Liabilities and Contingencies:
Textbook pages 611 -630
Note:
For this course, we only cover the following topics:
 Provisions (special type of liability recognized in financial statements)
 Contingent Liabilities (not recognized in statements, but may require disclosure)
Intermediate Accounting I
Dr. Nafis Rahman
Characteristics of Liabilities
Future sacrifices of
economic benefits
Characteristics
You already have some basic
knowledge about ‘Liabilities’ from
your beginning accounting course.
We will cover some special types of
liabilities in this class.
Arise from present
obligations
Result from past
transactions or events
Provisions
• Provisions (a type of liability)
‒ Liabilities of uncertain timing or amount of
future outflows
•
•
Obligations related to litigation, warranties or
product guarantees, business restructurings, and
environmental damage, etc.
Having greater uncertainty about the timing or
amount of the future expenditure required to
settle the obligations than other liabilities
3
Criteria for recognition of a provision
Recognize a provision if
a) A firm has a present obligation (legal or
constructive) as a result of a past event;
b) It is probable that an outflow of resources will
be required to settle the obligation; and
c) The amount of the obligation can be reliably
estimated
Note: The recording of the liability in the statement of
financial position is matched to an expense account in the
income statement.
4
Criteria for recognition of a provision
 Criterion (a): Present obligation
1) Legal obligation: a duty to act in a certain way
deriving from a contract or legislation
‒ Existing legislation
‒ New legislation virtually certain* to be enacted as
drafted or actually enacted
* Virtually certain: probability ≥ 90%
5
Criteria for recognition of a provision
 Criterion (a): Present obligation
2) Constructive obligation: an obligation that
derives from an entity’s actions where:
• By past practice, published policies, or specific
current statement, the entity has indicated to other
parties that it will accept certain responsibilities,
and
• As a result, the entity has created a valid
expectation that it will discharge those
responsibilities.
6
Example: Constructive obligation
Platinum Oil Co. drills for oil in locations worldwide.
Mindful of public perception in the wake of recent
oil spill disasters, Platinum Oil Co. has recently used
press and television advertisements to promote its
green credentials, and in particular, has pledged to
clean up any contamination that it causes. In the
year ended on December 31, 2017, Platinum Oil Co.
causes extensive contamination in a country with
no environmental legislation. Does a constructive
obligation exist on December 31, 2017?
9-7
7
Example: Constructive obligation
Solution:

Platinum Oil’s advertising campaign has created a
valid expectation that it will clean up any
contamination it causes.
• Parties that have had exposure to the advertising
campaign will expect that Platinum Oil will clean up the
contamination.

Therefore, Platinum Oil has a constructive
obligation.
9-8
8
Example: Legal & constructive obligation
Ikea, a world-famous furniture store chain, is under
legal obligation to refund money to customers who
return unwanted goods within a 28-day period. The
retailer has announced a policy of extending this
return period to 60 days, and accordingly has
printed this promise on its carrier bags. Does the
retailer have a present obligation as a result of a
past event?
9-9
9
Example: Legal & constructive obligation
Solution:
Ikea has a legal obligation to refund money for
unwanted goods within a 28-day period after the
sale
 Ikea has a constructive obligation to provide
refunds for 32 days beyond the 28-day legal
obligation for refunds.

9-10
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Criteria for recognition of a provision
 Criterion (b): Probable outflow of
economic resource
* Probable: More likely than not to occur (prob. > 50%)
Example: In 2015, Hyundai Motors sold 1 million cars with
an obligation to cover customers for the cost of repairs of
the cars with manufacturing defects within the first 3
years of purchase.
• The probability of expenditure on a certain car sold is
lower than 50%, but
• The probability of some expenditure on a group of 1
million cars sold is higher than 50% (i.e., probable).
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Criteria for recognition of a provision
 Criterion (c): a reliable estimate of the
amount of the obligation
• An entity will be able to determine an estimate in
most cases (rare exceptions)
• Despite some uncertainty over the amount or
timing of payments, we would record a liability
for the estimated cost of fulfilling the obligation.
• An estimate is based on management’s
judgment, experience of similar transactions, and
independent experts’ reports.
12
Initial measurement of a provision
 The best estimate of the expenditure to
settle the obligation at reporting date
• The amount that an entity would rationally pay to
settle or transfer the obligation to a third party
– Example: The price of an outsourcing contract to take
over warranty liability to customers
• The effect of the time value of money must be
considered, if it is material.
– If cash outflows are expected to occur over long periods
of time, the time value of money will be material.
13
Initial measurement of a provision
 The best estimate of the expenditure
a) Expected value
–
–
The probability-weighted outcome
= The sum of all possible outcomes times their
probabilities
Appropriate for provisions involving a large population
of items (e.g., provisions for product warranty or
returns)
b) Most Likely Outcome method
-NOT covered in this class
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Example: Expected value
Samsung sells smartphones with one-year warranty which covers
customers for the cost of repair of any manufacturing defect that
becomes apparent within the first one year of purchase. If the
company's past experience and future expectations indicate the
following pattern of likely repairs, what is the expected cost of
repairs? Ignore time value of money for simplicity.
Probability of event
The degree of
defects
Cost of repairs if all phones
sold suffered from the defect
during the warranty period
95.0%
No defect
$0 Billion
4.5%
Minor defect
$1 Billion
0.5%
Major defect
$6 Billion
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Example: Expected value
Solution:
The expected cost of repairs:
95% * $0 billion + 4.5% * $1 billion + 0.5% * $6 billion
= $75 Million
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Reviewing and adjusting provisions

Reviewing and adjusting provisions at each
reporting date
• An entity should estimate the amount and timing of
outflows using new information available at each
reporting date.
• An increase (decrease) in provision is recognized as a loss
(gain).
• If outflow is no longer probable, provision is reversed and
a gain is recognized.
• An increase in the liability due to unwinding the discount
over time is recognized as interest expense.
17
Product warranty

A warranty is a promise made by a seller to a
buyer to guarantee quantity, quality, or
performance of a product.
‒ Used as a sales promotion technique
‒ Entailing future costs of which the amount, due
date, and customers are indefinite
‒ Probable that these costs will incur in most cases
‒ Our textbook discusses two types of warranties…..
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Product warranty
1. Manufacturers’ original warranty
1) Warranty that the product meets agreed-upon
specifications in the sales contract at the date
of sale
• This warranty is an integral and inseparable part of the
sale of the product.
–The customer receives the warranty automatically at
the point of purchase.
–The seller cannot avoid the expenditures on repairing
faulty goods and thus bears a legal obligation.
19
Product warranty
1. Manufacturers’ original warranty
2) The estimated cost of fulfilling warranties is
recognized as provision for warranty and
warranty expense at the date of sale.
• The warranty expense is matched to the revenue from
the sale of the product.
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Product warranty
1. Manufacturers’ original warranty
3) Review and adjust warranty provisions at each
balance sheet date.
• The adjustment due to changes in estimates is
recognized as a loss (gain) on product warranty.
 The loss (gain) is not retroactively recorded in the
period of the product sale, unless fraud occurred or a
previous estimate was not made in good faith.
– DHB restated the warranty liability for bullet-proof
vests by $37 million because it had been
manipulated.
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Example: Original warranty
 Sale of personal computers with one-year warranty
of no manufacturing deficiency
•
•
•
•
•
Units sold on 12/31/2013: 10,000 units at $300 (paid in cash)
Expected return rate for repair: 3%
Expected repair cost per unit: inventory parts $5 and Wages Payable $10
Units returned in 2014: 170 units
At the end of 2014, the remaining balance on the Estimated Provision for
Warranty was reversed to zero since this type of computer units were not
produced anymore.
Ignore time-value (discount rate) effects.
Required: Prepare journal entries to summarize any aspects of the warranty for
2013 and 2014. The seller has the calendar year as its fiscal year.
Example: Original warranty (Solution)
Entry on 12/31/2013:
Dr. Warranty Expense
Cr. Provision for warranty
4,500
4,500*
* Estimated warranty costs = 3% of 10,000 units at $15 each = $4,500
Entry during 2014:
Dr. Provision for warranty
2,550
Cr. Parts Inventory [170*$5]
Cr. Wage payable [170* $10]
Dec 31, 2014:
Dr. Provision of Warranty [4500 - 2550]
1950
Cr. Gain on product warranty
850
1,700
1,950***
Product warranty
2. Extended warranty contract
1) Warranty that provides an additional service
beyond the manufacturer's original warranty
• This warranty creates a performance obligation
separable from the sale of the product (IAS 18.13).
–This obligation is different from the warranty
obligation embedded in the sale of the product.
2) The price of the extended warranty contract is
recognized as unearned warranty revenue at
the date of sale.
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Product warranty
2. Extended warranty contract
3) The revenue from rendering the extended
warranty service (warranty revenue) is recognized
over the contract period on a straight-line basis.
4) Costs incurred over the contract period are
recognized as warranty expense.
Note: The time value of money for customer prepayments
including unearned warranty revenue is not considered.
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Example: Extended warranty
Refer to the previous example for original warranty.
Assume that the seller sold extended warranties on
the 4,000 units sold in 2013 as follows:
• The price for the extended warranty: $30 per unit
• The warranty period: years 2015 and 2016
Required: Show journal entries to record the sale of
products and extended warranties in 2013 and
warranty revenue in 2015
Example: Extended warranty (Solution)
Entry in 2013:
Dr. Cash
3,120,000
Cr. Sales revenue
Cr. Unearned warranty revenue
3,000,000*
120,000**
* $300 per unit * 10,000 units
** $30 per unit * 4,000 units
[Notice that I could write the purchase journal entry in two parts]
Entry in 2015: (relating to year 2013 sales)
Dr. Unearned warranty revenue 60,000
Cr. Warranty revenue
* 120,000/2 years = 60,000
60,000*
Restructuring provisions

Definition of a restructuring in IAS 37
• A program that is planned and controlled by
management and materially changes either
‒ The scope of a business undertaken by an entity, or
‒ The manner in which that business is controlled
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Restructuring provisions

Examples of restructuring events
1) The sale or termination of a line of business
2) The closure of business locations or the
international relocation of business activities
3) Fundamental reorganizations
‒ Having a material effect on the nature and focus of
the entity's operations
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Restructuring provisions

Timing of recognizing restructuring provisions
1) Closures or reorganization
‒
Recognize a provision only after a detailed formal plan
is adopted and has started being implemented, or
announced to those affected by the plan*
* A constructive obligation for restructuring
2) Sale of operation
‒
Recognize a provision after a binding sale agreement
(i.e., a legal obligation)
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Restructuring provisions

Restructuring costs include only the direct
expenditures that are both
•
necessarily entailed by the restructuring and
not associated with ongoing activities.

Non-eligible costs for restructuring provisions
o
Retraining or relocating continuing staff
Marketing
Investment in new systems and distribution networks
Future operating losses
Losses or gains on the expected disposal of assets
•
o
o
o
o
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Example: Restructuring provisions
In the fourth quarter of 2021, management and the board of
directors publicly announced a plan to close the telemarketing
division in Chicago and move it to India. The impacted employees in
Chicago were notified that their jobs would be eliminated. To ensure
an orderly transition, management promised “stay pay” of $10,000
to any Chicago office employee who remained until they were
terminated by the Company in the third quarter of 2022. It is
estimated that 100 employees will take the ‘stay pay’ option.
Required:
How should the stay pay be accounted for using IAS 37? For the
purpose of this example, ignore any impact of the present value since
it would be immaterial. Show journal entries associated with
restructuring provision in 2022.
Solution: Recognizing restructuring provision
• The formal restructuring plan would appear to create a constructive
obligation using IAS 37.
– “Publicly announced a restructuring plan”
– “Promised stay pay”
• Thus, the estimated stay pay should be accrued and expensed in
the fourth quarter of 2021.
• Estimated total restructuring costs = $10,000 * 100 = $1,000,000
• Journal entry
Dr. Employee termination expense
Cr. Restructuring provision
1,000,000
1,000,000
Contingent liabilities
A possible obligation arising from past events but
not yet confirmed as a present obligation
‒ Possible: 5% ≤ probability ≤ 50%
‒ Only the occurrence or non-occurrence of
uncertain future events confirms the existence of
the obligation (criterion a  not satisfied)
Rule of Thumb:
Remote : probability <5%
Possible: 5% ≤ probability ≤ 50%
Probable: probability >50%
34
Examples: A possible obligation
1. Lawsuit
Existence of lawsuit against the company for which an unfavorable
outcome is not probable. The existence of the obligation of the
defendant can only be confirmed by the judgment of the courts or
a settlement. (criterion a  not satisfied)
2. Loan guarantee contract
•
•
•
A company provides a guarantee to a bank to support loans
taken up by another company (a past event).
The guarantor will have to pay the balance of the loan to the
bank only if the borrowing company defaults on the loans.
(criterion a not satisfied)
35
Contingent liabilities
 An obligation that does not meet the IAS 37
recognition criteria for a provision
A present obligation that arises from past events
(criterion a  satisfied), but
‒ It is not probable that an outflow of economic
benefits will be required to settle the obligation
(criterion b  not satisfied), or
‒ The amount of the obligation cannot be measured
with sufficient reliability (criterion c  not satisfied)
36
Example: A present obligation that cannot be
measured reliably

Breaching environmental laws
1) The tankers of a shipping company spilled a massive amount
of oil in a pristine area (past event)
2) The oil spillage is a violation of environmental laws, creating a
legal obligation (criterion a  satisfied)
3) The oil spillage provokes civil claims and investigations; so it is
probable that the firm will be required to pay some amount
of claims (criterion b  satisfied)
4) The amount of claims cannot be reliably measured until the
investigation is completed and all statutory and civil claims
are received from affected parties (criterion c  No)
37
Contingent liabilities

Disclosure rule
Not recognized as a provision, but
2. Disclosed in notes if the probability of loss
from that contingent liability is NOT remote.
1.
•
•
Remote: Probability < 5%
Contents of disclosure:
The nature of the contingent liability
b) An estimate of the financial effects
c) The uncertainty on the amount and timing of the
outflows
d) The possibility of any reimbursement
a)
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Subsequent events
1) The cause of a loss contingency occurs before the
year-end. An adjusting event that occurs for a
subsequent period provides evidence of the preexisting conditions.
 Recognize a provision as of the year-end
 Disclose detailed information in note
39
Subsequent events
2) The cause of loss contingency occurs during a
subsequent period. An adjusting event also occurs
for the subsequent period.
 Do not recognize a provision as of the year-end
 Disclose a contingent liability in note
40
Example: Subsequent events
A former employee filed a lawsuit against Hanover
alleging age discrimination and asking for damages of
$750,000. On December 31, 2012, Hanover’s lawyers
indicated that the likelihood of losing the lawsuit was
possible but not probable. On March 5, 2013, Hanover
agreed to pay the former employee $125,000 in return
for withdrawing the lawsuit. Hanover issued the
financial statements on April 1, 2013.
Required:
Determine the appropriate reporting for the situation
and prepare journal entries for the year 2013.
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Example: Solution
• Recognize a loss provision.
– The cause of the lawsuit occurred before
December 31, 2012.
– The settlement of the lawsuit in the subsequent
period confirms a possible obligation as a present
obligation (Criterion (a)  satisfied)
– A disclosure note is also appropriate.
• Journal entry
Dr. Loss – litigation
125,000
Cr. Liability – litigation
125,000
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Unasserted Claims
 A claim that has yet to be made by the other party,
but it is possible that such a claim will be made
1. If the claim is probable (Probability>50%), an unfavorable
outcome is also probable, and the outcome is estimable,
then treat it as a provision
2. If the claim is probable, but an unfavorable outcome is not
probable (probability <50%), then disclose contingent
liability.
3. If the claim is not probable (Prob <50%) or if the possibility
of unfavorable outcome from such a claim is remote (prob
<5%), then no need to disclose (do nothing).
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Contingent assets
 Suppose the company is the plaintiff in a case, and
the cause of a gain contingency occurs before the
year-end and the court’s decision in the subsequent
period confirms a gain for the plaintiff.
• The plaintiff cannot recognize the gain as an asset as of
the year-end unless the probability of inflow is “virtually
certain” (i.e., probability ≥ 90%)
• The plaintiff should disclose the anticipated gain in note.
• The stricter requirement for gain recognition than loss
recognition is consistent with conservatism.
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Summary
Depending a
future confirming
event?
Legal obligation?
or
Constructive obligation?
Probability > 50% ?
Prob. < 5% ?
Recognize
Provision
Disclose
contingent
liability
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