Kim Park (B): Liabilities
By: Khaled M. Motawie
As part of her plan to explore interesting accounting questions with her study group, Kim Park prepared a set of short case studies dealing with the recognition and measurement of liabilities. Kim knew from her earlier study group discussions that her fellow students expected her to prepare tentative answers to the questions she would raise in the meeting. In addition, the study group had encouraged her to illustrate her tentative answers with numerical illustrations using case data.
Kim understood from the background readings assigned for her accounting course that Generally Accepted Accounting Principles (GAAP) defined liabilities as
“Probable future sacrifices 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.”
Kim also knew under International Financial Reporting Standards (IFRS) that liabilities were recognized on the balance sheet when
“It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.”
Further, Kim understood from her readings that there was a special set of accounting rules covering contingent liability recognition and disclosure. Under GAAP, a contingency is an existing condition involving uncertainty as to possible gain or loss. When a contingency loss exists, it should be accrued as a liability when both of the following conditions are met: ❶ At the date of the financial statements it is probable that an asset has been impaired or a liability has been incurred, and
❷ The amount of the loss can be reasonably estimated.
If both of these conditions cannot be met, the contingent liability should be disclosed unless the probability of occurrence is remote. Under IFRS, Kim had noted that capitalized contingent liabilities were referred to as “provisions.” The term “contingent liability” was reserved for those contingent liabilities that were not capitalized. Otherwise, in Kim’s view, the GAAP and IFRS contingent liability accounting rules were similar.
We will need to understand meaning of “Accrued liabilities” and “Estimated Liabilities”:
Accrued Liabilities: Obligations related to expenses that have been incurred, but will not be paid until the subsequent period. Estimated Liabilities:
Some recorded liabilities are based on estimates because the exact amount will not be known until a future date. For example, an estimated liability is created when a company offers a warranty with the products it sells. The cost of providing future repair work must be estimated and recorded as a liability (and expense) in the period in which the product is sold. The estimated amount of product that will be returned is reported as a reduction from sales revenue in the year the sales are recorded.
Type| Probable| Reasonable Possible| Remote|
Subject to estimate| Record as liability| Disclose in note| Disclosure not required| Not Subject to estimate| Disclose in note| Disclose in note| Disclosure not required|
Estimated Liabilities Examples:
* Environmental problem.
* Product warranty.
Management must ensure that the correct amounts are reported on the balance sheet and income statement. This often requires estimations, assumptions, and judgments about the Timing of revenue and expense recognition and values for assets and liabilities. The auditors have to:
(1) Assess the strength of the controls established by management to...