Financial Accounting

Eleventh Edition
Pratt and Peters

Chapter 10
Introduction to Liabilities: Economic
Consequences, Current Liabilities and
Contingencies
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Copyright ©2021 John Wiley & Sons, Inc.

Learning Objective 1
Define liability and describe key economic consequences
associated with how liabilities are reported on the
financial statement.

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Liabilities
What is a liability?
• FASB - “Probable future sacrifice of economic benefits
arising from present obligations of a particular entity
to transfer assets or provide services to other entities
in the future as a result of past transactions or
events.”

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The Relative Size of Liabilities on the
Balance Sheet Liabilities/Total Assets
MANUFACTURING:
General Electric (manufacturer) 0.89
Chevron (oil drilling and refining) 0.39
RETAIL:
Kroger (grocery retail) 0.81
Lowe’s (hardware retail) 0.95
INTERNET:
Facebook, Inc. (social network) 0.24
Cisco (Internet systems) 0.66
GENERAL SERVICES:
AT&T (telecommunications services) 0.63
Wendy’s (restaurant services) 0.89
FINANCIAL SERVICES:
Bank of America (banking services) 0.89
Goldman Sachs (investment services) 0.91

Figure 10-1
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Reporting Liabilities on the Balance
Sheet: Economic Consequences
Shareholders and Investors
• Interest expense is tax deductible, but more debt means more risk
to shareholders
• Leverage is a common strategy
• Equity ownership is subordinated to creditors
Creditors
• Restrictive covenants regarding debt limits
Management
• When and how to borrow money are important decisions
• Wants to minimize debt on the balance sheet
• Less debt now improves ability to borrow in the future
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Concept Practice 1
For the following four transactions, indicate whether each of
these three ratios is increased, decreased, or unaffected:
return on equity, return on assets, debt/equity ratio.
1. Raise cash by issuing debt.
2. Purchase equipment and sign a note payable to finance it.
3. Pay cash to a bank to reduce an outstanding liability.
4. Issue common stock in payment of an outstanding
liability.

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Concept Practice 1 Solution

Return on Equity Return on Assets Debt/Equity

1. Unaffected Decreased Increased
2. Unaffected Decreased Increased
3. Unaffected Increased Decreased
4. Decreased Unaffected Decreased

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Learning Objective 2
Define current liability and list important financial metrics
that use current liabilities.

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The Relative Size of Current Liabilities
on the Balance Sheet Current Liabilities/Total Liabilities
MANUFACTURING:
General Electric (manufacturer) 0.31
Chevron (oil drilling and refining) 0.29
RETAIL:
Kroger (grocery retail) 0.39
Lowe’s (hardware retail) 0.40
INTERNET:
Facebook, Inc. (social network) 0.47
Cisco (Internet systems) 0.49
GENERAL SERVICES:
AT&T (telecommunications services) 0.11
Wendy’s (restaurant services) 0.08
FINANCIAL SERVICES:
Bank of America (banking services) 0.67
Goldman Sachs (investment services) 0.69

Figure 10-2
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Current Liabilities
Classification
• Expected to require the use of current assets (or the
creation of other current liabilities) to settle the
obligation.
Valuing current liabilities on the balance sheet
• Ignore present value (report at face value)
Reporting current liabilities
• Primary problem is ensuring that all existing current
liabilities are reported on the balance sheet.
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Review Question
Working Capital
Which of the following events does not have any impact on
total working capital?
a. The board of directors declares a cash dividend to be paid
next month.
b. Warranty expense is accrued.
c. Payment of salaries previously accrued.
d. Debt which was previously long-term matures next year.

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Review Answer
Working Capital
Which of the following events does not have any impact on
total working capital?
a. The board of directors declares a cash dividend to be paid
next month.
b. Warranty expense is accrued.
c. Answer: Payment of salaries previously accrued.
d. Debt which was previously long-term matures next year.

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Review Question
Current Ratio
If the current ratio is currently greater than 1.0, which
one of the following events would increase the current
ratio?
a. Purchase of inventory on account
b. Receipt of money from a customer prior to the
performance of service
c. Warranty expense is accrued
d. Sale of plant asset at a gain

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Review Answer
Current Ratio
If the current ratio is currently greater than 1.0, which
one of the following events would increase the current
ratio?
a. Purchase of inventory on account
b. Receipt of money from a customer prior to the
performance of service
c. Warranty expense is accrued
d. Answer: Sale of plant asset at a gain

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Learning Objective 3
Define determinable current liability and list several
of the most common ones.

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Outline of Current Liabilities

Determinable current liabilities Contingent liabilities

Accounts payable Lawsuits
Short-term debts Warranties
Short-term notes
Current maturities of long-term debts
Dividends payable
Unearned revenues
Third-party collections
Income taxes
Incentive compensation

Figure 10-3
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Determinable Current Liabilities
Accounts payable
• Usually associated with inventory
• Most popular source of financing for small business
Short-term debts
• Short-term notes
• Current maturities of long-term debts
Dividends payable
Unearned revenues
• i.e. gift certificates, airline industry, subscriptions
Third Party Collection
• i.e. sales taxes, social security taxes, employee income taxes
Income taxes The dollar value of these liabilities is
Incentive compensation relatively straight forward – hence
determinable
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Bonus Formulas of Selected Large
Corporations

Corporation Executive Bonus Formula

Aluminum Company 15% × Cash dividends
of America
Ashland Global 6% × Net income after tax
Boeing Company 6% × Net income before tax
DuPont 20% × [Net income after tax − (6% × Shareholders’ Equity)]
International Paper 6% × [Net income after tax − (6% × Shareholders’ Equity)]

Figure 10-4

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Concept Practice 3
Match the following determinable current liabilities with the correct description: accounts payable,
current maturities of long-term debts, dividend payable, unearned revenue, third-party collections,
income tax payable, and incentive compensation.
1. During 2019, John Deere declared $963 million in distributions to be made to its shareholders,
creating this kind of liability.
2. At the end of 2019, John Deere reported $2.3 billion in raw materials and supplies in the
inventory account on its balance sheet. In most cases, when these materials were purchased,
this liability was increased.
3. As of the end of January 2020, Home Depot carried over $30 billion in debt; about $1.8 billion
of this obligation is due within the current accounting period.
4. When you purchase apparel from Nordstrom, you pay more than the price of the item due to
sales tax. This creates a liability on Nordstrom’s balance sheet.
5. As of the end of 2019, Facebook still owed customers $269 million in services for which it had
already been paid.
6. Coca-Cola makes cash payments to its officers partially based on the company’s performance
against annually established targets. As these targets are achieved, Coca-Cola accrues this
liability.
7. Home Depot accrued this liability as it earned its profits and, by the end of 2019, it totaled
$55 million.

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Concept Practice 3 Solution

SOLUTION
1. Dividend payable 5. Unearned revenue
2. Accounts payable 6. Incentive compensation
3. Current maturities of long-term debts 7. Income tax payable
4. Third-party collections

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Learning Objective 4
Define contingency and describe the difference between
accounting methods for contingent losses and contingent
gains.

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Contingencies and Contingent
Liabilities
Contingent on some future event or activity in order to know the exact amount.
• Examples: warranties, coupons and lawsuits

Changes in estimate may be made in subsequent periods, when future event is

concluded.

Under IFRS, many of these transactions are reported in a balance sheet account
called “provisions”.
• Provisions are more readily booked than contingent liabilities because
IFRS provisions are accrued when the obligation is “more likely than
not,” while under U.S. GAAP contingent liabilities are accrued when
“highly probable,” which is a much higher threshold.

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Accounting for Loss Contingencies

Figure 10-5

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Warranties: Accrued Loss Contingencies
Warranties
A promise by a manufacturer or seller to ensure the quality or
performance of the product for a specific period of time
Record estimated expense and liability when products are sold (matching
concept):
Warranty Expense xx
Warranty Liability xx
As costs are incurred (usually in subsequent periods), charge expenditure
to warranty liability:
Warranty Liability xx
Cash xx
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Problem 10.4
While shopping on October 13, 2020, at the Floor Wax Shop, Tom Jacobs slipped and
seriously injured his back. Mr. Jacobs believed that the Floor Wax Shop should have
warned him that the floors were slick; hence, he sued the company for damages. As of
December 31, 2020, the lawsuit was still in progress, According to the company’s lawyers,
it was probable that the company would lose the lawsuit. The lawyers also believed that
the company could lose somewhere between $250,000 and $1,500,000, with a best guess
of the loss at $742,000. The lawsuit was eventually settled in favor of Mr. Jacobs on
August 12, 2021, for $690,000.
a. Discuss the issues that the Floor Wax Shop must address in deciding how to report
this lawsuit in its 2020 financial report.
b. If you were auditing the Floor Wax Shop, how would you recommend that this
lawsuit be reported in the 2020 financial report? Why?
c. Assume that a contingent liability of $742,000 is accrued on December 31, 2020.
What journal entry would the company record on August 12, 2021, the date of the
settlement?

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Problem 10.4
Parts a. & b. Solutions
a. Issues and recommendations:
o Likelihood?
o Probable
o Disclose?
o Yes
o Disclosure?
o Indicate range and level of probability ($250,000 -
$1,500,000)
b. Since probable and estimable, accrual the best estimate.

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Problem 10.4
Part c. Solution
Adjusting journal entry for 2020:
Contingent Loss 742,000
Contingent Liability 742,000
(Best guess in the range)
Journal entry at settlement (August 12, 2021):
Contingent Liability 742,000
Recovery of Contingent Loss 52,000
Cash 690,000

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Exercise 10.10
During 2020, Seagul Outboards sold 200 outboard engines for $250 each. The
engines are under a one-year warranty for parts and labor, and from past
experience, the company estimates that on average, warranty costs will equal
$20 per engine. As of December 31, 2020, 50 engines had been serviced at a
total cost of $1,400. During 2021, engines were serviced at a total cost of
$2,600. Assume that all repairs used cash.
a. Prepare the journal entries that would be recorded at the following times:
1) During 2020 to record the sale of the engines.
2) During 2020 to accrue the contingent loss on warranties.
3) During 2020 and 2021 to record the actual warranty cost incurred.
b. Assume that Seagul chose not to treat the warranty costs as contingent
losses. Instead, it chose to expense warranty costs as they were paid.
Compute the total net income for 2020 and 2021 for each of the two
accounting treatments.

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Exercise 10.10
Part a. Solution
1) General journal entry to record sale in 2020 (200 @ $250 each):
Cash 50,000
Sales Revenue 50,000
2) Adjusting journal entry to accrue the contingent loss on warranties in 2020 (200 @ $20):
Warranty Expense 4,000
Warranty Liability 4,000
3) General journal entry to record actual warranty cost incurred in 2020:
Warranty Liability 1,400
Cash 1,400
General journal entry to record actual warranty cost incurred in 2021:
Warranty Liability 2,600
Cash 2,600
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Exercise 10.10
Part b. Solution
Income effects for the revenue and warranty expense under the
two alternative for recognition of expense :
Accrue Expense Expense as Paid
2020 2021 2020 2021
Revenue 50,000 --- 50,000 ---
Warranty Expense (4,000) --- (1,400) (2,600)

Note: the accrual method recognizes the expense in the same

period as the revenues generated by the sale.

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Review Question
Loss Contingency
If a loss contingency related to a lawsuit against a firm is
deemed to have a remote probability of requiring
ultimate payment, then the proper accounting treatment
of the loss contingency will
a. increase the debt/equity ratio.
b. increase the debt/asset ratio.
c. have no effect on earnings per share.
d. increase the quick ratio.

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Review Answer
Loss Contingency
If a loss contingency related to a lawsuit against a firm is
deemed to have a remote probability of requiring
ultimate payment, then the proper accounting treatment
of the loss contingency will
a. increase the debt/equity ratio.
b. increase the debt/asset ratio.
c. Answer: have no effect on earnings per share.
d. increase the quick ratio.

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Learning Objective 10A
Describe the basic accounting treatment for defined
benefit pension plans and postretirement health care.

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Pensions
A sum of money paid to a retired or disabled employee
usually based on years of service
• Pension plans are an important part of the employee’s
compensation package
• Most plans are structured so that an employer
periodically make cash payments to a pension, a legal
entity distinct from the sponsoring company
• The employer’s cash contributions plus the income
generated through the fund’s management provide the
cash that is distributed to employees upon retirement

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Defined Contribution Plan
• Employer agrees to make a series of contributions of a
specified amount (contribution guaranteed, not
benefits)
• Less expensive than Defined Benefit Plans
• 401(k)s are very common
• The entry to record period contributions is very
simple:
Pension Expense XX
Cash XX
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Defined Benefit Plan
• Employer promises to provide each employee with a specified
amount of benefits upon retirement
• Benefits must be predicted, therefore several assumptions and
estimates are required
• The entry to record the estimated liability is simple, but the
calculations can be quite complicated:
Pension Expense XX
Pension Liability XX
• The entry to record periodic payment
Pension Liability XX
Cash XX
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Postretirement Healthcare and
Insurance Costs
• Postretirement Healthcare and Insurance Costs
o Most large companies provide some after retirement
benefits for healthcare and insurance. These items
must be estimated and expensed over the employees
tenure with the company. These entries are similar to
pension entries.

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Learning Objective 10B
Explain why deferred income tax liabilities are
reported on the balance sheet and describe the basic
accounting treatment.

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Deferred Income Taxes
Generated by the discrepancy between income and expenses for
taxation (specified by IRS) and financial reporting (specified by
GAAP).
These differences are either permanent or timing differences.
Example:
• Equipment purchased on 1/1/20 for $9,000
• 3-year useful life
• No salvage value
• Double-declining-balance for income tax purposes
• Straight-line for financial reporting purposes
• Income tax rate of 30%
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Income Tax Effects Due to DDB
Depreciation
Excess
DDB Straight Line (Under) Tax Benefit
Year Depreciation Depreciation Depreciation Tax Rate (Disbenefit)
2018 $6,000 − $3,000 = $3,000 × 30% = $900
2019 2,000 − 3,000 = (1,000) × 30% = (300)
2020 1,000 − 3,000 = (2,000) × 30% = (600)
Total $9,000 $9,000 $ 0 $ 0

DDB depreciation = [$9,000 − accumulated depreciation] × 2 [(straight-line rate (33%)]

Straight line depreciation = $9,000/3 years
Figure 10B-1
2018 Deferred income tax benefit $900

2019 Deferred income tax disbenefit $300

2020 Deferred income tax disbenefit $600

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Deferred Income Tax Liability (selected
U.S. Companies)
Company Deferred Tax Liability (millions) Percentage of Total Assets
Southwest Airlines $3,482 13%
Merck 1,470 2%
Avis Budget 2,189 10%
Procter & Gamble 8,656 8%

Source: 2019 Annual Reports.

Figure 10B-3

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The Conservatism Ratio
• A measure of the extent to which reported income is
conservative can be constructed from information disclosed in
the annual report and is as follows:
Reported Income Before Taxes ÷ Taxable Income
• The intuition underlying this ratio is based on the premise that
for tax purposes companies accelerate tax-deductible expenses
and defer taxable revenues as long as is allowable for income tax
laws.
• Taxable income (taxable revenues – tax deductible expenses),
the denominator of the ratio, reflects a very conservative
measure of a company’s income.

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Conservatism Ratios
Knowing that companies defer taxable income, a measure around
1.0 or less indicates relative conservatism. Reported income is
increasingly less conservative at ratios greater than 1.0.
2016 2018
MANUFACTURING
General Electric 0.11 0.36
SERVICE
Federal Express 0.91 1.96
RETAIL
Walgreens 0.99 0.70

Source: 2016 and 2018 annual reports.

Figure 10B-4

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Disclosures from AT&T’s Deferred
Income Tax Footnote
2019
Current portion due $1,792
Deferred 1,701
Total tax expense $3,493
Effective income tax rate 18.9%

Figure 10B-5

LO 10B Copyright ©2021 John Wiley & Sons, Inc. 44

Review Question
Recognition of Deferred Tax Liability
An increase in deferred tax liability is recognized when
a. the tax accountant omits the taxable revenue from the tax
returns.
b. net income measured under GAAP is greater than taxable
income on tax returns because of temporary timing
differences.
c. the amount of tax paid to the government is more than that
calculated by the accountant on the company’s tax return.
d. a tax audit by the IRS causes and increase in taxes due from a
previous year’s tax return.

LO 10B Copyright ©2021 John Wiley & Sons, Inc. 45

Review Answer
Recognition of Deferred Tax Liability
An increase in deferred tax liability is recognized when
a. the tax accountant omits the taxable revenue from the tax
returns.
b. Answer: net income measured under GAAP is greater than
taxable income on tax returns because of temporary timing
differences.
c. the amount of tax paid to the government is more than that
calculated by the accountant on the company’s tax return.
d. a tax audit by the IRS causes and increase in taxes due from a
previous year’s tax return.

LO 10B Copyright ©2021 John Wiley & Sons, Inc. 46

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