CHAPTER 1: APPLYING ACCOUNTING CONCEPTS AND PRINCIPLES

Contents
1.1 General and Specific Objectives
1.2 Introduction
1.3 Establishing Accounting Information System
1.4 Generally Accepted Accounting Principles (GAAP)
1.5 Summary
1.6 Answers to Check Your Progress Exercises
1.7 Model Examination Questions
1.8 Reference Books
1.9 Glossary

1.1 GENERAL AND SPECIFIC OBJECTIVES

General objectives
At the end of this session you will be able to understand accounting principles according
to the requirements of the Financial Accounting Standard Board.

Specific objectives:
This chapter specifically aims to discuss the basic accounting concepts and procedures
used in the preparation of financial reports. It also discusses in detail the generally
accepted accounting principles.

After studying this chapter, you will be able to:

- describe the development of accounting concepts and principles
- identify and illustrate the application of basic accounting concepts and principles
- solve exercises and problems related to the GAAP.

1.2 INTRODUCTION

Accounting is one of the areas of specialization identified under business education.

Accounting has often been called the “Language of Business.” It is because people in
Business world such as owners, managers, suppliers, bankers, and creditors use

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accounting information to efficiently utilize resources and effectively perform business
activities. Although accounting is vital to every unit of society, Business organizations,
governmental agencies, and all other units of society must use accounting as a basis for
controlling their resources and measuring their accomplishments. Accounting is equally
important to the successful operations of all types of organizations, that is, both profit
making and not-for-proof organizations, among others; require accounting information to
perform their operations and to achieve their objectives.

The historical development of accounting practices has been closely related to economic
developments. In the earlier periods, a business enterprise was very often managed by its
owner, and the accounting records and reports were used mainly by the owner-manger in
conducting the business. Bankers and other lenders often relied on their personal
relationship with the owner rather than on financial statements as the basis for making
loans for business purposes. If a large amount was owed to a bank or supplier, the
creditor often participated in management decisions.

1.3 ESTABLISHING ACCOUNTING INFORMATION SYSTEM

Organizations depend on information systems in order to stay competitive. Information is

just as much a resource as other assets. Productivity which is crucial to staying
competitive, can be increased through better information systems. Accounting, as an
information system identifies, collects, processes, and communicates economic
information about an entity to a wide variety of people. Information is a useful data
organized such that correct decisions can be based on it. An accounting information
system (AIS) is a collection of resources designed to provide data to a variety of decision
makers according to their needs and entitlement. Accounting information system is the
combination of personnel, records, and procedures that a business used to meet its need
for financial data.

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Components of accounting information systems
The major components of AIS includes:
- Information systems
- Information technology and
- System development

Information systems
The term information system suggests the use of computer technology in an organization
to provide information to users. A computer-based information is a collection of computer
hardware and software designed to transform data into useful information.

Information Technology:
AIS includes the use of information technology to provide information to the users. In
addition to computers, information technology includes other processing technologies
such as machine-readable bar codes and scanning devices, and communication protocols
and standards.

System development
System development activities basically consists of three general phases: System
analysis, system design and system implementation.

System analysis: it involves formulating and evaluating solutions to system problems.

The emphasis of systems analysis is on the objectives of the entire system under
consideration.

Steps in analyzing existing accounting information system are:

1. Survey the present accounting information system
2. Identify the information needs
3. Identify the systems requirements
4. Develop a systems analysis report

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The general objectives of systems analysis can be summarized as follows:
- To improve the quality of information
- To improve internal control and
- To minimize cost, where appropriate

Systems design
It is the process of specifying the details of the solution selected by the system analysis
process. It includes the evaluation of the relative effectiveness and efficiency of
alternative system design in light of the overall system requirements.

System implementation
It is the process of placing the revised or newly designed procedures and methods into
operation. System implementation includes testing the solution prior to implementation,
documenting the solution, and reviewing the system when it actually begins operation to
verify that the system functions according to the design specification.

Features of accounting information systems

A good accounting information systems whether manual or computerized, includes four
features: control, compatibility, flexibility, and favorable cost/benefit relationships.

Control
Management needs control over operations. Internal controls are the methods and
procedures used to authorize transactions and safe guard assets.

Compatibility
A compatible system is one that works smoothly with the business operations, personnel,
and organizational structure.

Flexibility
A well-designed system is flexible if it accommodates changes without needing a
complete overhall.

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Favorable cost/benefit relationship
In trying to achieve control, compatibility and flexibility, management should strive for a
system that offers maximum benefits at a minimum cost that is with a favorable
cost/benefit relationship. Therefore, the best criteria to be satisfied in developing an
accounting information system is cost-effectiveness balance. According to the cost
effectiveness balance principle the benefits to be obtained from an accounting
information system should at least be equal to the cost of developing it.

Check your progress exercise 1

1. Define accounting information system, system analysis, system design, and
system implementation.
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2. Identify the features of accounting information systems
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3. List the steps in analyzing existing accounting information systems
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1.4 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAPS)

The need for GAAP

These principles assure us that similar economic events will be reported in the same
manner by every one. Infact when several acceptable alternatives exist for recording an
economic event-say, inventory cost flow or depreciation, these ground rules requires us to
disclose which alternative was used in the financial statements. Since every one must
follow GAAP, the result is consistent with the system of financial reporting that provides

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users of financial statements with information that is reliable, understandable, and
comparable to prior years and among companies.

Generally, the main reasons that need application of accounting principles and concepts
are:
1) the development of business firm in size and form,
2) the complexity of business transactions,
3) the need for separation of management from owners, and
4) the demand for accurate, timely and relevant, information by users.

The meaning and development of GAAP

Generally accepted accounting principles is a technical accounting terms, which includes
conventions, concepts, rules, standards, principles and procedures that are necessary to
define accepted accounting at a particular time. Responsibility for the development of
accounting principles has rested primarily on practicing accountants and accounting
educators, working both independently and under the sponsorship of various accounting
organizations. These principles are also influenced by the business practices and customs,
ideas and beliefs of the users of the financial statements, government agencies, stock
exchanges, and other business groups.

The structure of GAAP

Generally accepted accounting principles are conventions, concepts, standards, rules,
principles and procedures that are necessary to accounting practice at a particular time.
We can categorize these principles, conventions and concepts into three major areas, as
follows:
1) Basic assumptions (concepts)
2) Basic principles
3) Basic modifiers

Basic assumptions
GAAP rest on these four basic assumptions or concepts
1. The business entity concepts
2. The accounting period concepts

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 3. The going concern concept
4. The stable-dollar concept

1. The business entity concept:

It means that a business entity is considered as a separate and distinct from its owners for
accounting purposes. Each business entity is treated for accounting purpose as generating
its own revenue, incurring its own expenses, owning its own assets, and owing its own
liabilities. It is not legally true if the entity is a proprietorship or partnership. But
accountants report on the economic substance of activity, and that may not always reflect
the legal form.

Businesses are perceived and treated as a distinct and separate entities regardless of the
legal concept because in so far as a specific business is concerned, the purpose of
accounting is to record its transactions and periodically report its financial positions and
profitability. Consequently, the records and reports of the business should not include
either the transactions of another business or the personal assets and transactions of its
owner or owners.

Note: The legal entity concept may not go in accordance with the business entity concept
depending on the type of the business enterprise, i.e whether the business is a sole
proprietorship, partnership, or corporate entity. The two concepts match for corporate
entity but not for the other two business enterprises.

2. The accounting period concept:

It assumes that it is necessary to measure accounting income for periods of time less than
the life of a company, and that the information obtained will not be precise but it will be
useful.

3. The going concern concept:

A business enterprise purchase and holds assets for use in its operations. The market
value of those assets may change over time. However, the accounting records for those
assets are not adjusted to reflect the market value changes. This is because of the
continuing (going) concern concept. The concept assumes that the business enterprise
continues its operations (at profit) for indefinite period of time. Therefore, unless there is

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strong evidence to the contrary, a balance sheet is prepared under this assumption. As a
going concern, the assets used in carrying on the business operation are not for sales.
Therefore, since the assets are held for use, not for sale, their current market values are
not particularly relevant and need not be shown.
Note that, if a business enterprise is to be sold or liquidated, the cost principle and going
concept do not apply in preparing the financial statements. In such cases, the estimated
market values become more useful and informative.

4. The stable-dollar concept/unit of measurement

Accounting transactions are measured, recorded and reported in terms of monetary unit.
In the process of measuring, recording and reporting the monetary unit is treated as a
stable unit of measure like a gallon, a kilometer, etc. However, the monetary unit is not a
stable unit of measure nevertheless, accountants use a monetary unit as a standard unit of
measurement in their reports. Money is a common unit of measure that we can use to
record economic transactions and prepare financial statements. The stable-dollar concept
assumes that the monetary unit of measure does not change in value over time, even if
infact it does. The assumption assures objectively in reflecting data on the financial
statements.

Check your progress exercise – 2

1. State business entity concept
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2. State the going concern concept
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Basic principles
The basic principles that form the frame work for the practice of accounting includes:
1. The cost principles
2. The matching principles

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 2.1 The expense recognition principle
2.2 The revenue recognition principles
3. The full disclosure principle
4. The consistency principle
5. Objective principles

1. The cost (historical cost) principle

Exchange price gives us objective and verifiable evidence of values for the goods and
services we may exchange with others. On the day that exchanges are made we record the
exchange prices in our accounting records. We call these prices historical costs. As time
goes on, the values of the items we acquired may increase or decrease. But we will not
record these changes in values, for several reasons. One major reasons is that we will not
have objective, verifiable evidence for the items of new value.

A second reason, we use historical costs is that we have acquired goods and services for
use in our operation. Once they are acquired, the price we paid for them is relevant not
what they worth today. The cost principle requires us to record goods and services at the
prices we paid for them and not change those values later, when prices increases.

For example: If a business paid $30,000 for a plot of land to be used in carrying its
operation, the purchase should be recorded at $30,000. It does not make any difference if
the buyer or any other competent out side appraiser think that the land worth more or less
than 30,000. Therefore, the J. Entry would be recorded in the buyer’s book as follows:

Land -------------------------------30,000
Cash -----------------------------------30,000

2. The matching principle

How well or bad the company is doing is measured and reflected to users (investors,
creditors, etc) on the income statement prepared for a period of time. The income
statement tries to measure the business’s earnings by comparing the revenue with expense
of that period which is covered by the income statement.

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The matching principles means that after the revenue for an accounting period has been
determined, the costs associated with that revenue must be deducted in order to measure
net income. The term matching refers to the close relationship that exists between certain
costs and the revenue realized as a result of incurring those costs.

For example, the expenditure made for advertising to attract customers and generate
sales. The out lay for advertising is a cost to be matched against the sales that it promotes.
The recognition of uncollectible accounts is also supported by the matching principles.
Uncollectibles arise from credit sales to customers who fail to pay their bills. To match
this expense (uncollectible amounts), it becomes important to estimate what part of the
credit sales is to be uncollectibles in the future. Since the matching principles involves
determining the revenue realized and expenses incurred, it becomes necessary to know
how to determine these items and match them to determine the net income.

2.1 The Expense Recognition Principle

This principle tries to answer the question “when the expense is incurred and when a cost
becomes an expense?” Every thing the business acquires is a cost before it becomes an
expense. The costs are shown on the balance sheet since they represent an asset. These
are usually termed as unexpired costs. Which means the business has paid them but it has
not got any economic benefits from them. When the assets are used up, their costs do
expire and reported as expired costs-expenses, which means the business paid for them
and has received the economic benefits represented by costs. These appear on the income
statement of the firm. An important question is therefore, when do we move costs from
the balance sheet to show them as expense on the income statement? There are different
ways of recognizing expense. Some of these are:

a) Expenses can be recognized by direct association:

Certain costs can be associated directly with revenue of the period. For example,
when a merchandise inventory is bought, its cost is an asset and when that
merchandise inventory is sold, the cost becomes an expense and appears on the
income statement as cost of goods sold.
b) Expenses can be recognized by rational allocation:

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 Certain costs become expenses through systematic and rational allocation process
over a period of time. Their expenses are not directly associated and identified with
revenue rather they are related to an accounting period. A good example of such
expense is depreciation expense on plant assets.

c) Expenses can be recognized immediately

Certain costs which do not fit the above two conditions (methods) will be recognized
as soon as they are incurred. A good example of such expense is salary expense paid
to employees.

Check your progress exercise 3

1. A business bought a car for 20,000 Birr two years ago and currently, the market
value of the car is 25,000. Assume buyer A offers Birr 24,000 to purchase the car
and buyer B offer Birr 25,000 for the same car. If the businessman decides to
increase (adjust) the cost of car from the record by 5,000 since its market value is
25,000, which principle is violated? Why?
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2.2 The Revenue Recognition Principle

Revenue is the inflow of assets that results from producing goods or rendering services.
But an important question to be raised is “when do we record revenue?” The earning of
revenue does not take place all at on point in time. The earning process extends over a
considerable length of time. The answer to the above question will be answered when the
following conditions are met.
i. The earning process is essentially completed, and
ii. An exchange has taken place

By considering these conditions there are few different ways of revenue recognition
principles, which are appropriate for different companies at different time periods.

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a) Revenue can be recognized at the point of sales:
This principle of revenue recognition is appropriate for most merchandising firms. For
these companies, the required conditions for revenue recognition are met at the time the
goods are sold or services are rendered to customers. The journal entry will be:

Cash (As/Receivable) -------------------------XXX

Sales (Revenue) --------------------------------XXX
b) Revenue can be recognized at point of cash receipt:
According to this principle revenue is recognized when cash is collected. This may be
appropriate for certain firms, which are engaged in professional services like physicians,
attorney, etc. and this principle is widely used in cash basis of accounting. Even if the
method has little theoretical justifications; it has got the advantage of:
i) Simplicity in revenue recognition and
ii) Avoiding of problems of estimating loss from uncollectibles accounts
The journal entry will be:
Cash ---------------------------------XXX
Sales (revenue) ------------------------XXX

c) Installment method of revenue recognition

It is not unusual for business enterprises to sell goods on an installment plan. Installment
seals is a credit sale that involves cash down payment and the remaining balance to be
paid/collected on an equal installment which covers long period of time. When sales are
made on an installment basis, revenue recognition differs from an ordinary credit sales.
Under the installment sales method of accounting each payment collected consists of a
part of recovery of cost and part of gross profit, in the same ratio that these two elements
existed in the original sale. For example, assume that a car dealer sells an automobile for
Birr 100,000 that costs him Birr 70,000. The Gross profit percentage for this sale is 30%.
The dealer would recognize 70% of any collection as recovery of costs, and 30% as
realized gross profit. The entries to record the initial sale, assuming a perpetual inventory
system and no down payment are:

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 As/Receivable – Installment sales -----------100,000
Installment sales -------------------------------------100,000

Cost of installment sales -----------------70,000

Inventory -------------------------------------70,000

At the end of the period, the company closes out the installment sales account and cost of
installment sales account by the following entry:
Installment sales -------------------------------100,000
Cost of installment sales -------------------------70,000
Unrealized Gross profit --------------------------30,000

If the company collects Birr 40,000 from the installment sales receivable during the
period, the entry will be:
Cash -----------------------------------40,000
As/Receivable – Installment sales ------------40,000
Unrealized Gross profit -------------12,000
Realized gross profit ------------------12,000
To record cash collection and realized gross profit (30% of the collection)
From Birr 40,000, Birr 28,000 is cost recovery and Birr 12000 is the gross profit realized.

d) Percentage of contract completion method:

For firms engaged in construction activities revenue recognition could take long period of
time. For such firms revenue should be recognized on the basis of percentage of
completion method, that is, based on reasonable estimates of the projects progress. The
amount of revenue to be recognized in any year is determined by comparing the costs
incurred in that year to the total estimated costs for the entire project. Some times the
physical progress of the project may be easily determined by engineers. If this rate of
completion is determined, it can be used to estimate the revenue realized during the
specific period. The rate will be multiplied by the total contract price (fixed price) to
determine the revenue realized. Therefore, in percentage of completion method, we can

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use either the engineers’ estimate or the accounting estimate to determine the revenue to
be recognized.
i) Revenue to be recognized for a period of time using engineers’ estimate can
be computed by the following algorithm;
Rd = Rc x Cp ; where,
Rd = Total revenue recognized todate
Rc = Completion Rate
Cp = Total contract price
Therefore, Rt = Rd – Rt – 1
Where, Rt = Revenue recognized during the current period,
Rt – 1 = Total Revenue recognized until the end of the
previous period.
ii) Revenue to be recognized todate using the accounting estimate is computed as
follows:
Rd = Acd/Tne x Cp; where,
Rd = Revenue recognized to date
Acd = Actual costs incurred to date
Tne = Newly estimated total costs to complete
the project
Cp = Total contract price
Example 1
ABC construction private Ltd. Company engaged into a contract with XYZ Trading
Company to construct a building. They agreed upon contract price is Birr 550,000 and
ABC estimated that the project costs approximately Birr 440,000 and takes four years to
complete it. The following data were gathered from the records of ABC Company during
the life of the project.

Y1 Y2 Y3 Y4
Current costs incurred on the
Contract 112,000 110,000 129,000 109,000
Remaining costs estimated to
Complete the project 328,000 221,000 108,000 -

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Percentage of completion of the
project as per engineers’ estimate 25% 50% 80% 100%

Required
1) Compute the annual revenue and gross profit to be recognized from the project using
the engineers’ estimate
2) Compute the annual revenue and gross profit to be recognized from the project using
the accounting estimate

Solution
Rt = Rc x Cp – Rt-1 = Rt = Rd – Rt – 1
Let R1 = Revenue for year 1
R2 = revenue for year 2
R3 = Revenue for year 3 and
R4 = Revenue for year 4
Computations
R1 = 25% x 550,000 – R0
= 137,500
R2 = 50% x 550,000 – R1
= 275,000 – 137,500
= 137,500
R3 = 80% x 550,000 – (137,500 + 137,500)
= 0.8 x 550,000 – 275,000
= 165,000
R4 = 100% x 550,000 – (R1 + R2 + R3)
= 550,000 – (137,500 + 137,500 + 165,000)
= 110,000

Gross profit calculation

Year 1 Year 2 Year 3 Year 4
Revenue recognized 137,500 137,500 165,000 110,000
Costs incurred 112,000 110,000 129,000 109,000
Gross profit 22,500 27,500 36,000 1000

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Solution 2
Revenue and gross profit under the accounting estimate can be computed by using the
following schedule:

Year 1 Year 2 Year 3 Year 4

Contract price (Fixed price) 550,000 550,000 550,000 550,000
* Costs incurred to date (a) 112,000 222,000 351,000 460,000
Remaining estimated costs to
Complete (b) 328,000 221,000 108,000 ______
Total newly estimated costs when
The project is completed (c = a + b) 440,000 443,000 459,000 460,000
Percentage of completion a/c = 0.25 0.5 0.76 100%

Computation of revenue for each year:

Year 1 = 0.25 x 550,000 = 137,500
Year 2 = 0.50 x 550,000 – 137,500 = 137,500
Year 3 = 0.76 x 550,00 – (137,500 + 137,500) = 143,000
Year 4 = 100% x 550,000 – (137,500 + 137,500 + 143,000) = 132,000
Costs incurred each year _______ 112,000 110,000 129,000 109,000

Gross profit 22,500 27,500 14,000 23,000

Check your progress exercise 4

1. Differentiate the terms expense and costs by giving examples.
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2. What are the two conditions that should be met to recognize revenue? What is the
term revenue refers to?
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3. Adequate disclosure principle:
All financial statements and accompanying statements should include the necessary data
that helps to facilitate the users’ understanding. Thus all relevant information to the users
must be disclosed. However, full disclosure does not mean that everything must be
disclosed. That would be too costly. A balance must be maintained between the cost of
disclosing information and its relevance to users. Basically, if the information will make a
difference in investors’ or creditors’ decisions, it should be disclosed. Therefore, the
criteria for disclosure is based on the value judgment rather than objective facts.
Information to be disclosed are usually made on notes accompanying the financial
statements. Adequate disclosures are necessary for both historical facts and subsequent
events to the issuance of financial statements. The following are some examples:
 Change in accounting methods used by the business,
 Accounting principles followed by the firm,
 Summary of significant accounting policies,
 Contingent liabilities and commitments,
 Events subsequent to the date of financial statements
 Replacement costs of inventory and plant assets,
 Other relevant information’s

4. The consistency principle

Accounting information is useful if it can be compared with similar information for the
same company through time and with similar information between companies at the same
time. But you have seen, there are alternative generally accepted accounting principles
for a number of areas – inventories, depreciation and uncollectibles, for example. For
accountants, the consistency principle means that the same accounting method will be
applied to accounting events from period to period. If we choose LIFO inventory costing
method, we would expect to continue using LIFO year after year. We can’t use other
methods in other years. Does that mean that the companies can never switch to another
accounting method? No, companies can do change accounting methods but only if they
can demonstrate that the new method is preferable to the old one. If a change is made, the

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full disclosure principle requires that the nature and the effect of the change and the
reasons for the change be disclosed in the financial statement when the change is made.

5. Objective evidence principle

This principle requires that accounting records be based on verifiable evidences such as
business transactions between independent parties

Basic modifiers
We can’t always follow the basic principles blindly. Sometimes practical consideration
force us to modify our basic principles. The following are two basic modifiers:
a) Materiality
b) Conservatism

a) Materiality
Materiality is a relative thing, i.e what is material for one business may be immaterial for
another business. The way accountants apply the material modifier is to determine
whether or not they think the item in question will affect decisions of users of the
financial statements. If it will, then it is material and must be reported in accordance with
generally accepted accounting principles.

Example At year-end company’s receivable subsidiary ledger has the balance that is
15,000 greater than the control account. That is pretty big-or is not? We can’t tell until we
know the total of all receivable balance. If the control account has a balance of 150,000
the 15,000 difference is 10% and that is material. But if the general ledger control balance
is 150,000,000, the 15,000 difference is only 0.01%. When compared to the 150,000,000
it is immaterial.

b) Conservatism
The conservatism modifier states that when two methods of handling a particular event is
encountered, you should use the method which understate the net income or net assets.
Conservatism modifier means that we will select the alternative least likely to overstate
net income or net assets.

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SUMMARY

An accounting information system is a collection of resources designed to transform data

to information. This information is communicated to a wide variety of decision makers.
The term accounting information system broadly include transaction processing cycles,
the use of information technology and the development of information systems.

The accounting profession is guided by basic accounting concepts and principles. In

recording business transactions and in preparing financial statements accountants apply
these principles and concepts.

Accounting principles differ from the principles related to the physical sciences.
Accounting principles are developed by individuals to help in making accounting data
more useful in an ever-changing society. These principles are continually reexamined and
revised to keep pace with the increasing complexity of business operations.

ANSWERS TO CHECK YOUR PROGRESS EXERCISES

I. Check your progress exercise 1

1. Accounting information system (AIS) is a collection of resources designed to provide
data to a variety of decision makers according to their needs and entailment.
- System analysis is a phase of system development which involves formulating
and evaluating solutions to the system problems.
- System design: is the process of specifying the details of the solution selected by
the system analysis process.
- System implementation: is the process of placing the revised or newly designed
procedures and methods into operation.
2. The features of AIS are:
- Control
- Compatibility
- Flexibility
- Favorable cost/Benefit analysis

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3. The steps in analyzing existing AIS are:
- To survey the present AIS
- To identify the information needs
- To identify the system requirements
- To develop the system analysis report
II. Check your progress exercise 2
1. Business entity concept states that the business enterprise is separate and distinct
from the person who supply its assets for accounting treatment.
2. The going concern states that the business enterprise will continue by generating
profit for indefinite period of time.
III. Check your progress exercise 3
1. Historical cost principle
B/c the Historical cost principle states that the assets purchased and recorded in the
accounting record should not be adjusted by market value, estimated value or offer values
rather it should be shown on the original cost.
IV. Check your progress exercise 4
1. Costs are value of items paid by the business to get the economic benefits in the
future. They are reported in the balance sheet asset of the business. When assets
are used up, their costs do expire and reported as expired costs, which are called
expenses.
2. The two conditions to recognize revenue are:
- Completion of the earning process essentially,
- Taking place of exchange process.
- Revenue is the inflow of assets that result from producing goods or rendering of
services.

MODEL EXAMINATION QUESTIONS

A. Discussion Questions
1. What is the advantage of having well established AIS?
2. Why should the most objective evidence available be used as the basis for data
reported on financial statements?

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3. If a complete and accurate picture of an enterprise’s success or failure is desired, what
accounting period must be used to report operation?
4. What are the two conditions that must be fulfilled to recognize revenue?
5. When there are several acceptable ways (alternative accounting methods) that could be
used, the method used by an enterprise should be disclosed in the financial statements.
Why? Give examples of accounting methods that fall in this category.
6. If significant changes are made in the accounting principle applied from one period to
the next, why the effect of these changes should be disclosed in the financial statements?
7. The accountant for a large department store charged the acquisition cost of pencil
sharpener to an expense account, even though the asset had an estimated useful life of 10
years. Which accounting concept supports this treatment of the expenditure?
8. Why do the financial statements of a business present its activities separate from its
owner’s activities?
9. State briefly matching principle

B. Exercise
Each of the following statements represents a decision made by an accountant. State
whether or not you agree with the decision. Support your answer with reference to
generally accepted accounting principles that are applicable in the circumstance.
1. In preparing the balance sheet detailed information as to the amount due from
hundreds of customers was omitted. The total amount was presented under the caption
“Accounts Receivable”
2. Used equipment with an estimated useful life of 5 years and no salvage value, was
purchased early in the current fiscal year for Br. 150,000. Since the company planned to
purchase new equipment, costing Br. 250,000, to replace this equipment at the end of five
years, depreciation expense of 50,000 was recorded for the current year. The depreciation
expense thus provided for one fifth of the cost of replacement.
3. All minor expenditures for office equipment are charged to an expense account.
4. Merchandise transferred to other parties on a consignment basis and not sold was
included in merchandise inventory.

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5. Land, used as a parking lot, was purchased 10 years ago for 50,000. Since its market
value is now 90,000, the land account is debited for 40,000 and a gain account is credited
for that amount. The gain is presented as other income in income statement.

C. Workout
XYZ company makes all sales on the installment basis and recognizes revenue at the
point of sale. Condensed income statements and the amounts collected from customers
for each of the 1st three years of operations are as follows:

First year Second year Third year

Sales ---------------------------------------402,500 340,000 372,000
Cost of merchandise sold ---------------265,650 227,800 241,800
Gross profit -------------------------------136,850 112,200 130,200
Operating expenses -----------------------64,000 51,500 60,700
Net income --------------------------------72,850 60,700 69,500
Cash collected from sales of 1st year -125,000 157,500 120,000
Cash collected from sales of 2nd year – 95,000 145,000
Cash collected from sales of 3rd year - - 110,000

Required Determine the amount of net income that would have been reported in each
year if the installment method of recognizing revenue had been employed, ignoring the
possible effects of uncollectibles accounts on the computation.

D. A construction company engaged into a contract with a municipality to construct a ten

Km highway in the city. The contract price was Br. 900,000 and the construction
company estimated the total project will cost Birr 750,000 at the date of the contract. The
following are actual and estimated data obtained from the records of the construction
company.
Year 1 Year 2 Year 3
Construction costs incurred during
the year 125,000 495,000 145,000
Est. costs to complete the project
At the end of the year 625,000 55,000 –

22
Operating expense incurred 15,000 30,000 22,000

Required
Compute the amount of income from operation using percentage of contract completion
meted of revenue recognition.

REFERENCE BOOKS

1. Fees and warren: Principles of Accounting, 16th edition

2. George H. Bonder
And: Accounting information system, 7th edition
William S.Hopwood
3. Horn Grean, Sundem, & Elliot : Introduction to Financial Accounting, 8th edition,
(2002)
4. Kieso & Wayandat : Intermediate Accounting, 9th edition, (1998)
John Wiley & Sons, Inc.

GLOSSARY

1. Adequate disclosure: the concept that financial statements and their

accompanying foot notes should contain all of the pertinent data believed
essential to the reader understands of an enterprises financial status.
2. Business entity concept: the concept that states the accounting applies to
individual economic units and each unit is separate & distinct form the persons
who supply its assets.
3. Conservatism: the concept that dictates that in selecting among alternatives, that
method or procedure that yields the lesser amount of net income or asset values
should be selected.
4. Consistency: the concept that assumes that the same generally accepted
accounting principles have applied in the preparation of successive financial
statements.
5. Cost principle: the principle that assumes that the monetary records for properties
and services purchased by a business should be maintained in terms of its cost.

23
6. Going concern concept: the concept that assumes that a business entity has a
reasonable expectation of continuing in business at a profit for an indefinite
period of time.
7. Matching principle: the principle of accounting that states all revenue should be
matched with the expenses incurred in earning those revenues during a period of
time.
8. Materiality – the concept that recognizes the practicality of ignoring small or
insignificant deviations from generally accepted accounting principles.
9. Periodicity concept:
concept: the concept that states that the life of a business entity should
be broken into segment periods for accounting purposes.

24
CHAPTER 7: ACCOUNTING FOR LIABILITIES

Contents
7.0 Aims and Objectives
7.1 Introduction
7.2 Distinguishing Current Liabilities from Long Term Liabilities
7.3 Valuation and Recognition of Current Liabilities
7.4 Accounting for Current Liabilities
7.4.1 Definitely Measurable Liabilities
7.4.2 Liabilities that Must Be Estimated
7.4.3 Contingent Liabilities
7.5 Presentation of Liabilities in the Financial Statements
7.6 Summary
7.7 Answers to Check Your Progress Questions
7.8 Model Examination Questions
7.9 Glossary

7.0 AIMS AND OBJECTIVES

The aims of this chapter are to explain the features and accounting treatments of
liabilities and contingencies.

Having studied this chapter you will be able to:

- define liabilities and describe how the definition is applied in practice
- describe how liabilities are reported in the financial statements
- distinguish between current liabilities and long-term liabilities
- explain how current liabilities are valued,
- distinguish between definitely measurable liabilities and liabilities dependent on
operating results;
- identify liabilities that are estimated in amount, and describe how they are
estimated, recorded and reported
- identify contingent liabilities and describe how they are reported

25
7.1 INTRODUCTION

Liabilities have been defined by the FASB as “probable future sacrifice of economic
benefits arising from present legal, equitable, or constructive obligations of a particular
enterprise to transfer assets or provide service to other entities as a result of past
transactions or events affecting the enterprise”. This definition contains the following
significant elements that need to be explained:

A liability is a result of past transactions or event.

event. Thus, a liability is not recognized
until incurred. This part of the definition excludes contractual obligations from an
exchange if promises of performance by both parties is still in the future. The signing of
labor contract that obligates both the employer and the employee does not give rise to a
liability in current accounting practice, nor does the placing of an order for the purchase
of the merchandise.

A liability represents a legal, equitable or constructive obligation.

obligation. Generally, the
obligation rests on a foundation of legal rights and duties.

A liability must involve a probable future transfer of assets or services. Although

liabilities result from past transactions or events, obligations may be contingent up on the
occurrence of another event sometime in the future.

A liability is the obligation of a particular enterprise,

enterprise, i.e. the enterprise that has the
responsibility to transfer assets or provide services.

Liabilities may be classified as current or non-current. Generally, the distinction between

current and non-current liabilities is an important one because such distinction is
necessary for computation of working capital as a measure of liquidity of an enterprise.

26
7.2 DISTINGUISHING CURRENT LIABILITIES OF LONG-TERM LIABILITIES

If a liability arises in the course of an entity’s normal operating cycle, it is considered

current if it must be satisfied with current assets before the operating cycle is completed
or within one year, which ever is longer.
- Current liabilities are: obligation for which payment will require:
a) the use of current assets, or
b) the creation of other liabilities, in one year or one operating cycle, which
ever is longer.
- Current liabilities include payables to suppliers and employees, accruals for taxes,
rents, advance collection from customers, obligation that are payable on demand
with in one year even though the liquidation may not be expected within that year.
- Current liabilities do not include those obligation that could not be settled within
one operating cycle such as obligations that will be liquidated by the issuance of
shares of stock.

7.3 VALUATION AND RECOGNITION OF CURRENT LIABILITIES

In theory, the measure of any liability at the time it is incurred is the present value of the
required future cash out flow. In practice, however, most current liabilities are recorded at
face amount. The difference between the present value of a current liability and the
amount that will be paid at maturity usually is not material because of the short term
period involved.

The recognition of liabilities poses two questions:

i) Does the liability exist?
ii) If it exists what is the amount of obligation?

In some cases both these two questions are answerable. While in other instance there is
uncertainty as to the amount. In extreme cases both existence and amount becomes
uncertain. The remaining topics of this chapter covers in depth these three conceptual
accounting issues related to current liabilities.

27
7.4 ACCOUNTING FOR CURRENT LIABILITIES

The accounting treatment for current liabilities are divided into:

- liabilities that are definite in amount,
- liabilities that are estimated in amount, and
- contingent liabilities

Several examples of liabilities in each area are presented to clarify the accounting issues
involved.

7.4.1 Definitely determinable current liabilities

Representative of liabilities that are definite in amount in which the amount of an
obligation and its due date are known with reasonable certainty because they result from
contracts or the operation of statutes. It includes accounts payable, short term notes
payable, miscellaneous operating payables including salaries, payroll taxes, property and
sales taxes, accrued expenses, unearned revenues etc. Some of the problems arising in
determining the balances to be reported for liabilities that are definite in amount are
described in the following sections.

a) Trade accounts payable

The term accounts payable usually refers to the amount due for the purchase of materials
by a manufacturing company or merchandising enterprise. There are two ways of
recording trade As/payable

i) Gross method
Here trade As/payable are recorded at face amount. The purchase discount ledger account
is credited for discounts taken, and a material amount of discounts available to be taken at
the end of an accounting period is accrued by a debit to allowance for purchase discounts
(a contra-liability ledger accounts). In the income statement (specifically in the cost of
goods sold section), the purchases discount is deducted from purchases to give net
purchase.

28
 ii) Net method
In this method purchase is recorded net of discounts at time of purchases. For discount
not taken (for one reason or another), the purchase discount lost account is debited. In the
income statement, the amount of purchase discount lost is reported under other expense.

Example:
Example: Assume that the following information is taken from ‘XYZ’ company for the
year 2003.
(a) Purchases Birr 1000,000 of merchandise on terms 2/10,n/30.
(b) Paid invoices for purchases of Birr 500,000 with in the discount period
and for purchases of Br. 200,000 after the discount period.
(c) Estimated at the end of year 2003 that 80% of Br. 300,000 outstanding
trade accounts payable would be paid with in the discount period.

Required: Give journal entries and show balance sheet presentation related to trade
As/payable using Gross method

Solution
Gross method
a) Purchase ------------------ 1000,000
As/payable -------------------- 1000,000
b) Trade As/payable (500,000 + 200,000) ---------- 700,000
Purchase discount (500,000 x 0.02) ------------------------- 10,000
Cash (700,000 – 10,000) ------------------------------------- 690,000
c) Allowance for purchase discount (80% x 300,000 x 0.02) -------- 4800
Purchase discount ---------------------------------------------------------4800

Balance sheet presentation

Trade As/payable ----------------- 300,000
Less: Allowance for purchase discount 4800
Carrying amount ----------------------295,200
----------------------295,200

29
Check your progress – 1
Give journal entries and show balance sheet presentation related to trade As/payable
using net method for the example above
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------

b) Loan obligation (In the form of promissory note payable)

- Promissory notes payable as evidence of borrowing is some how stronger than the
accounting for promissory notes payable in the eye of law to be enforced for
collection. The accounting for promissory notes payable resembles that of
accounting for promissory notes receivable. In this section we concentrate on
short-term promissory notes payable (commercial paper is a good example).
- When a promissory note bears a current fair rate of interest, its face amount is
equal to its present value at the time of issuance where as when a promissory
notes bears no interest or an unreasonably low rate of interest, the present value of
the note payable is less than its face amount. The discount of the note is converted
to interest expense over the term of the note.

For example, assume that in January 1, year 5, ABC company uses a one year non
interest bearing note as a consideration for the acquisition of furniture, the face amount of
the note is Birr 240,000 and the current fare rate of interest on the note is 12%
compounded monthly (i.e appropriate present value table for 1% (12% /12 month) per
period for three decimal places).

Required:
(i) Record the journal entries for the month of Jan. and Feb.
(ii) Show the presentation of the Notes payable in ABC Company’s
Balance sheet on Feb. 28 year 5, the end of the fiscal period.

30
Solution
i) Jan. 1 Furniture (240,000 x P 12% = 240,000 x 0.887) ------- 212,800
Discount on Notes payable (240,000 – 212,800) -------------27,120
Notes payable -------------------------------------------------------240,000
* “P” represents present value
Jan. 31 Interest expense (240,000 – 27,120) x 0.12 x 1/12) ---------2129
Discount on notes payable --------------------------------------2129
Feb 28 Interest exp ((240,00 – (27,120 + 2129)) x 0.12 x 1/12 ------------2150
Discount on note payable ---------------------------------------------2150

ii) Balance sheet presentation

Notes payable ---------------------------------------------------240,000
Discount on notes payable (27,120 – 2129 – 2150) --------22,841
--------22,841
Carrying amount of notes payable ---------------------------217,159
---------------------------217,159

c) Refinancing of short-term debt

Refinancing means replacing short-term debt with either long term debt or equity
securities, or replacing the short-term debt for more than one operating cycle from the
date of the balance sheet. The accounting issue is “does the short term debt expected to be
refinanced on long term basis classified as current liabilities.
- Accounting standards requires that short term debt be classified as current
liabilities unless the enterprise demonstrates both of the followings:
(1) Intentions to refinance the debt on long term basis, and
(2) Ability to carry out the refinancing
- Ability to refinance on long-term basis must be demonstrated either by:
a) Actually issuing long-term debt or equity securities to replace short
term debt, or,
b) Entered into a contract to replace short term debt at maturity
- When a short-term debt is not classified under current liability, the reason should
have to be disclosed in the note to the financial statements.

d) Cash dividends:

31
When board of directors declares a cash dividend, the corporation incurs a legal
obligation to pay the dividend on a specific date. Because of short-duration between cash
dividend declaration and payment, it is a current liability. Unless dividends in arrears on
cumulative preferred stock are declared by the board, they are not liabilities but disclosed
in the note to the financial statements. Undistributed stock dividends is reported in stock
holders’ equity section, not as a current liability because no cash outlay is required.

e) Accrued Liabilities
Accrued liabilities (Accrued expenses) are obligations that come into existence as a result
of past contractual commitments
i) Accrued salaries – As you have learned in accounting for payroll chapter,
there are various deductions to calculate the liability for the net pay. Some of
the deduction include pension contribution, employee income tax with held.
Contribution for labor union, credit association contribution, etc. Normally, no
journal entry is made for salaries and wages expenses until payment is made.
A liability for unpaid salaries and wages is recorded at the end of accounting
period to match the revenue with expenses with in the appropriate fiscal year.
The hypothetical journal entry will be:
Salary expense ------------- XXX
Payroll tax expense ------------------- XXX
Income tax payable --------------------------XXX
Pension contribution payable ------------XXXX
Credit association payable -----------------XXX
Accrued payroll -----------------------------XXX

Note that accrued payroll shows the net pay which is accumulated and going to be paid in
relatively short period of time.
ii) Property taxes: are sources of revenue for the government there are two
accounting issues which arise relating to property taxes:
(1) When should the liability for property taxes be recorded? The answer for
this question can be seen from two different perspectives. On the one
hand, because the legal liability for property taxes arises on the lien date,

32
 the liability may be recorded on that date. On the other hand, the AICPA
took the position that accrual of property tax during the fiscal year of
taxing units instead of recognizing the whole liability on the lien date. The
latter approach is advocated in this text.
(2) To which accounting period does the tax expense relate? Because property
taxes are expenses associated with the use of property during the fiscal
year of the taxing units, it seems reasonable to expense the property taxes
during that period (instead of expensing it all on the lien date).
For example, Assume the ABC company’s plant assets are subject to property
taxes by Oromia region taxing units. The fiscal year of Oromia Region’s
taxing unit cover the period from April to March 31. The property tax of Br.
144000 are assessed on Jan10 year 5, covering the fiscal year starting April 1,
year 5. The lien date is April 1, year 5, and taxes are payable in two
installments of Br. 72000 each on July 15, year 5 and on November 15, year 5.
Assume ABC company accrues property taxes on monthly basis, the
following journal entries are recorded using AICPA Recommendations.
1) April 1 – lien date (the date at which liability comes into
existence)
No journal entry is required
2) At the end of April, May and June, year 5, for recording of
monthly property tax expenses
Property tax expense (144 ,000  12) --------12000
Property tax payable -------------------------12000
3) July 15, year 5, payment of the first installment of tax bills
Property tax payable (3 x 12000)-------- 36000
Prepaid property tax (3 x 12000) --------36000
Cash ------------------------------------------72000

33
Check your progress exercise – 2
1. Pass the journal entries for the remaining nine months
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------

f) Miscellaneous operating liabilities

Certain, obligations are completed, by their nature based on the operating results. At the
end of the year the operating results are known, therefore, there is no problem of
determining such liabilities. The problem arise in determining such obligation for interim
reporting purposes. Obligations dependent on operating results include Bonuses, Income
Taxes, Royalties, etc.

Income tax
Business enterprises based on the ownership are classified into sole proprietor ship,
partnership and corporations. The first two, namely, solepropritorship and partnership are
not taxable entities and therefore do not report income tax liabilities in their balance
sheet. However, corporation is taxable entity and income tax liability appear in the
balance sheet of such entities, corporations usually are required to make payments of
their estimated tax liabilities in advance. The remaining tax not covered by the estimated
payment is payable by the due date of the income tax return.
The journal entries related to the income tax accounting treatment are:

1) At the time of payment (if the tax is paid advance)

Prepaid tax expense -------------------XXX
Cash -------------------------------------XXX
2) When it expires:
Income tax expense -------------------XXX
Prepaid tax expense -------------------XXX
3) Adjustments for the accrued tax
Income tax expense -------------------XXX
Income tax payable --------------------------XXX

34
4) At the time of paying the accrued debt (for tax)
Income tax payable ----------------XXX
Cash ------------------------------------XXX

Bonus
Some contract calls for conditional payments in an amount dependent on revenue (sales)
or income (after deduction of expense). For example, royalties payment which is 20% of
sales, rent which is composed of a fixed Br. on 2000 a month and 1% of sales, employee
compensation based on 10% income in excess of Br. 5000.

When a bonus is based on income, there is a difficulty of determining which expenses are
going to be deducted. There could be three different assumptions applying the percentage
based on:
1) Income before income tax and bonus
2) Income after bonus but before income tax
3) Net income (i.e income after bonus and I/Tax)

Example: Assume that Sony enterprise has a bonus plan under which marketing staff
receives 25% of the income in excess of 25000 earned by the business. Income for the
business amounted to Birr 95,000 before the bonus and income taxes. The income tax
rate is assumed to be 35%. Calculate the bonus expense for Sony enterprise under each of
the following assumption.

Assumption 1 – Bonus is based on income before income taxes and Bonus.

Bonus = 0.25 (95,000 – 35,000) = 15,000
Assumption 2 – Bonus is calculated based on income after bouns but before income
taxes.
Let B refers to Bonus:
Bonus = 0.25 (95000 – 35000 – B)
B = 0.25B + 15000
B – 0.25B = 15000
0.75B = 15000
15000
B=  20,000
0.75

35
Assumption 3 – Bonus is calculated based on income after bonus and income taxes
Let B = Bonus
T refers to Tax
B = 0.25 (95000 – 35000 – B – T)  B = 15000 – 0.25B – 0.25T ---- (1)
T = 33,250 – 0.35B -------- (2)
Substituting (2) in (1)
B = 15000 – 0.25B – 0.25 (33,250 – 0.35B)
B = 15000 – 0.25B – 8312.50 + 0.0875B
1.1625B = 6687.50
6687.50
B=
1.1625
B = 5752.69 (Rounded to two decimal places)
Note that the journal entry in all the three cases is:
Bonus expense -------------------------XXX
Bonus payable --------------------------XXXX

Bonus expense is an operating expense, which is reported in the income statement where
as bonus payable is a liability account, which is reported under balance sheet.

7.4.2 Liabilities that must be estimated

The amount of an obligation is generally established by contract or accrues at a specified
rate. There are instances, however, when an obligation clearly exists on a balance sheet
date but the amount ultimately to be paid cannot be definitely determined. Because the
amount to be paid is not definite does not mean the liabilities can be ignored or given a
contingent status. The claim must be estimated from whatever data are available.

Current liabilities that are estimated in amount and frequently found on financial
statements are the following:
1) Refundable deposits, representing the estimated amount to be refunded to
depositors;

36
 2) Warranties for service and replacements, representing the estimated future claims
by customers as a result of past guarantees of services or products or product part
replacements;
3) Customer coupon (premium) offers, reprresenting the estimated value of future
prizes to be distributed as a result of past sales or sales promotion activities.
4) Compensated absences, representing the estimated future payment attributable to
past or service of employees.

1. Refundable deposits
Liabilities of a company may include an obligation to refund previously collected
amounts from customers as deposit.

Example: ABC Company sells its products in drums that cost Br. 10 each. The estimated
life of a drum is two years. The selling price for each drum for each product is Br. 100
which includes Birr 9 as a deposit on the drum. It is estimated that 60% will be returned
for a refund, and the remaining 40% will be kept by customers. Assume that 1000 drums
are purchased by ABC Company in the first year of operations, and 80% units are sold
for cash, prior to the end of the year, 360 of the drums are returned for cash refunds. The
journal entries for the above information would be as follows:

1) To record purchase of 1000 drums Br. 10 each

Returnable drums ----------------------10,000
Cash --------------------------------------10,000
2) To record sales of 800 units at 100 Birr each for cash
Cash ------------------------------80,000
Sales (800 x 91) ---------------------------72,800
Deposit on returnable drums --------------7200
3) To record return of 360 drums and a refund made at 9 Birr per drum:
Deposit on returnable drums --------------------3240
Cash (360 x 9) ---------------------------------------3240

37
4) To recognize the estimated lose on non-returnable drums
Deposit on returnable drums ---------------------2880
* Loss on non-returnable drums ----------------320
Returnable drums (40% x 800 = 320 x 10) 3200
* Loss = (10 – 9) x 320 = 320

2. Warranties for services and replacements

Most business enterprises give warranties to replace or repair if it proves unsatisfactory
during some specified time period. Estimating the liability under product warranty is a
very difficult task. There are two alternative ways of recording such liability.

(1) Recording at the time of sale

a) Estimated liability at the time of sale:
Product warranty expense -----------------------XXX
Liability under product warranty ---------------XX
b) Recording actual cost of servicing customer claims
Liability under product warranty ------------XXX
Cash (As/payable, inventory) ----------------XXX
(2) Not recording at the time of sale
a) Estimated liability at the time of sale
No entry
b) Recording actual cost of servicing customers claims
Product warranty expense -----------------------XXX
Cash (As/payable, inventory) ----------------------XXX
c) Potential claims outstanding are recorded at the end of the accounting
period
Product warranty expense --------------------------XXX
Liability under product warranty --------------------XXX

38
Example XYZ company sells TV with a two year warranty. Past experience indicates
that 10% of all TV sets sold will need repairs in the first year, and 20%, will need repairs
in the second year. The average repair cost is Birr 50 per/TV set. The number of TV sets
sold in 2002 & 2003 was 5000 and 6000, respectively. Actual repair costs were Br.
12,500 in 2002 and Br. 55,000 in 2003, all in cash. The journal entry for the above
information for the two years will be:

In year 2002: To record estimated warranty expense for the year:

5000 x (0.1 + 0.20) x Br.50 = Br. 75000
Product warranty expense --------------------75000
Estimated liability under product warranty ------------75000
To record the actual cost for repair
Est. liability under product warranty ------12500
Cash ------------------------------------------------12500

In year 2003: To record yearly warranty expense

Product warranty expense (6000 x 0.3 x 50) ------90000
Estimated liability under product warranty ---------90000
To record the actual cost incurred for repairs
Estimated liability under product warranty ------55,000
Cash ---------------------------------------------------55000

If the estimated amount for the product warranty is understated or over stated, that
amount will be recorded by adjusting entry in the year such understatement or
overstatement is identified by debiting or crediting product warranty expense and liability
under product warranty.

3. Service contracts
Household appliances like refrigerator, TV, etc. are sold with their associated servicing
contracts for a specified period of time. The amount received for such service contracts
constitute unearned revenue that will be earned by performance over the term of contract.
The actual cost of servicing will be recognized as expenses.

39
For example:
example: Jupiter Trading PLC sells photocopy machine service contracts for 200
Birr each on July 1, year 3. Assume 500 such service contracts are sold and agreed to
service the photocopy machine for one year. 50% of the contract revenue is recognized
on December 31, of year 3, which is the end of the fiscal period. Cost of Br. 20,000 is
incurred in servicing the contracts in this period. The remaining will be serviced in the
coming fiscal period. The journal entries related to the above information is shown
below:

July 1 To record collection of cash and signing of contract:

Cash (Br. 200 x 500) -----------------------------100,000
Unearned service contract revenue ------------------100,000
To record the realized revenue for 6 months (50%)
Dec. 31 Unearned service contract revenue (100,000 x 0.5) --------50,000
Service contract revenue --------------------------------------------50,000
To record actual costs incurred to service
Service contract Exp. ----------------20,000
Cash inventory As/payable -----------20,000

The remaining balance in the unearned service contract revenue is a current liability that
will be reported in the balance sheet.

4. Coupons (premiums)
For promotional purpose, coupon is issued which is exchangeable for prizes such as cash
or merchandises. The liability for the issuer is the cost of the prizes that are expected to
be claimed (redeemed) by the customers.

Example
Assume that in year 5 Moha industry issued coupons that may be redeemed for prizes
costing 5000 Birr if all coupons are presented for redemption. Experience indicate that
only 90% of the coupon will be presented for redemption, therefore the liability is Br.
4500 (i.e 5000 x 0.9). Assume further, the following transactions are occurred and
recorded:

40
 A merchandise of prize is bought for 5200 Br.
Inventory of prize merchandise -----------------5200
Cash (As/payable) -----------------------------------5200
 Customers present coupons costing Br. 3200
Promotional expense ----------------3200
Inventory of prize merchandise ---------3200
 Adjusting entry for the coupon’s outstanding (at the end of year 5)
Promotional expense (4500 – 3200) -------------1300
Liability for coupons outstanding ------------------1300

At the end of year 5, in the current asset section, the inventory of prize merchandise
costing Br. 2000 (5200 – 3200) is reported. And in the current liability, a liability for
coupons outstanding of Br. 1300 is reported. In the income statement a promotional
expense of Br. 4500 is reported for the current period.

Check your progress exercise – 3

In year 10 XYZ company issued coupons that may be redeemed for prizes costing 3000 if
all coupons are presented for redemption. From past experience it is estimated that 70%
of the coupons will be presented for redemption. Assume that customer presented
coupons during year 10 exchangeable for prize merchandise costing 1400, and the
company acquired prize merchandise at a cost of 3200.
Required
Prepare the necessary journal entry related to the coupons.

5. Compensated Absences:
Compensated absences include payments by employers for employees for vacation,
holiday, illness, or other personal activities. Employees often earn paid absences based up
on the time employed. Generally, the longer an employee work for a company, the longer
the vacation allowed, or the more liberal the time allowed for illnesses. At the end of any
given accounting period, a company has a liability for earned but untaken compensated
absences that should be recorded as debit to appropriate expense account and credit to
liability account.

41
7.4.3 Contingent Liabilities
As defined in FASB statement No. 5:
Contingencies are an existing condition, situation, or set of circumstances involving
uncertainty as to possible gain or loss an enterprise that will ultimately be resolved when
one or more future events occur or fail to occur.

The likelihood that the future event will confirm the loss may be probable (likely to
occur), reasonably possible (more than remote but less than likely) and remote (slight
change of occurring) that indicate estimated loss contingencies to be recorded.

In other words, there are three levels in expectation of recurrence of future events, which
in turn indicates their treatment. These are:

Accrual, disclosure, or neither of them. Based on such treatment future events may be:
(i) Probable – likely to occur
(ii) Reasonably possible – more than remote but less than likely or
(iii) Remote – slight chance of occurring

Contingencies are generally classified in to two:

Loss contingencies and Gain contingencies.

Loss contingencies
There is uncertainty as to the existence and amounts of loss to be incurred. Examples
include:
 Collectivity of receivable (i.e loss as a result of failing to collect)
 Liabilities for product warranties
 Risk of damage to property
 Pending or threatened litigation
 Selling of receivable or other assets with recourse basis

42
 To explain their accounting treatment, scrutinize the following:

Probability as to the existence of Contingency can be Contingency can not be reasonably

loss contingency reasonably estimated estimated
(1) Probable Accrued and included in Not accrued but reported in a note to
the financial statements the financial statements
(2) Reasonably possible Not accrued but reported Not accrued but reported in a note to
in a note to the financial the financial statements
statements
(3) Remote Note accrued, a note to Not accrued, a note to the financial
the financial statements is statements is permitted but not
permitted but not required required.
* Accrual of loss contingencies:
As we can see and understand from the table above, a loss contingency is accrued
(a) Only when it is probable that an asset has been impaired or a liability incurred
(b) The amount of the loss can be reasonably estimated
(c) It must be probable that a future event will confirm the existence of the loss.

You have to note that a mere exposure to risk does not require accrual of a loss. For
example, the possibility that injury claims will be made against a business enterprise does
not indicate that an asset has been impaired or that a liability has been incurred, therefore,
it is not going to be accrued.

In some instances it is difficult to give single amount estimate for the loss contingency.
Instead a range of loss can be reasonably estimated. With in the range no single amount
appears to be a better estimate than any other amount.

The minimum amount in the range should be accrued, and any additional possible loss is
disclosed in the note to the financial statements. To illustrate assume that ABC company
had a lawsuit on the balance sheet date but the amount of the damage has not been yet
decided. A reasonable estimate of the compensation is 100,000 and 400,000; no amount
in between is a better estimate than any other. ABC Company records this as follows:

Litigation loss -----------------100,000

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 Liability from litigation ---------100,000

The company also discloses the additional Br. 300,000 (400,000 – 100,000) in the note to
the financial statements.

* Loss contingencies that are not accrued:

- Loss contingences that do not meet the criteria for accrual, but which are at least
reasonably possible as to their existence, are disclosed in the note to the financial
statement. The disclosure should indicate the nature of the contingency and
provide an estimate of possible loss, or state that such all estimates cannot be
made. An example of such a loss contingency is a legal action whose unfavorable
outcome is reasonably possible, but a reasonable estimate of a loss cannot be
made. Disclosure may not be required for a loss contingency involving lawsuits
not yet filed. Unless it appears probable that the lawsuit will be filled and that an
unfavorable outcome is reasonably possible.
- For loss contingency, which are remote as to their existence, disclosure may still
be permitted, but not required. Such contingencies include guarantees of
indebtedness of others and agreements to require receivables that had been sold.

Gain contingencies
As to the accounting treatment of gain contingencies, the following table gives you
important information:
Probability that Contingency can be reasonably
contingency exists estimated
1. Probable No accrued, except in unusual
situations: disclosure in a note to
the financial statements is required.
2. Reasonably possible No accrued, but reported in a note
to the financial statements in a
manner that does not give an
impression that realization of gain
is likely
3. Remote No disclosure is required
Contingency cannot be reasonably
estimated
Not accrued but reported in a
note to the financial statements
in a manner that does not give
an impression gain is likely
Not accrued, but reported in a
note to the financial statements
in a manner that does not give
an impression realization of gain
is likely to occur.
No disclosure is required

Because of conservatism, contingencies that might result in gains are not recorded until
the gains are realized or realizable.

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7.5 PRESENTATION OF LIABILITIES IN THE FINANCIAL STATEMENTS

The liability section of the balance sheet is usually dividend between current and non-
current liability as previously discussed at the beginning of the chapter. Two questions
arise in connection to the presentation of current liabilities in the presentation of current
liabilities in the balance sheet.

i) What is the basis of ordering current liabilities?

Current liabilities may be reported in the order of maturity or according to amount
(largest to smallest). These two basis can’t be achieved together, and the compromise
is to rank current liabilities in order of amount (largest to smallest) unless difference
in maturity dates are significant those maturity shortly after the balance sheet date
comes first.
ii) What is the extent of disclosure required for different types of current
liabilities?

The extent of disclosure depends on the purpose for which the balance sheet is
prepared. The liabilities for presentation in annual reports is not as detailed as that
prepared for short-term loan application.

7.6 SUMMARY

Current liabilities are obligations for which payment will require the use of current assets
or the creation of other current liabilities in one year or one operating cycle, if longer,
certain liabilities are definitely measurable as to their amounts and existence, while others
are dependent on the operating results of the business enterprise to determine the amounts
of the liability such as bonus payable. In other extreme, some other liabilities are
uncertain as to their existence and amounts, such liabilities are known as contingent
liabilities.

7.7 ANSWERS TO THE CHECK YOUR PROGRESS – EXERCISES

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Check your progress exercise 1

1. (a) Purchase (1000,000 x 0.98) -----------------980,000

Trade. As/payable --------------------------------------980,000
(b) Trade As/payable (700,000 x 0.98) -------------686,000
Purchase discount lost --------------------------------4000
Cash ---------------------------------------------------690,000
(c) Purchase discount lost (300,000 x 0.2 x 0.02) -----------1200
Trade As/payable 1200
Note – If 80% is estimated to be paid with in the discount period, the remaining
20% is paid after the discount period.

Check your progress exercise 2

* At the end of July, august, September, year 5, there is a prepaid property tax for each
month as follows:
Property tax expense --------------9000
Prepaid property tax --------------9000
* At the end of October year 5
Property tax expense ----------------9000
Property tax payable ----------------9000
* November 15, year 5, payment of the second installment of property tax bill
Property tax payable ------------------------ 9000
Prepaid property tax (5 x 9000) -----------45,000
Cash --------------------------------------------54000
* At the end of November and December, year 5 and Jan, Feb, March, year 6
Property tax expense ------------------9000
Prepaid property taxes ------------------9000

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Check your progress exercise 3
* To record purchase of prize merchandises:
Inventory of prize merchandise -------------------3200
Cash (As/payable) ---------------------------------------3200
* To record redemption of coupons by the customers
Promotion expense -----------------------1400
Inventory of prize merchandise -----------1400
* To record adjusting entry for coupons outstanding (2100 – 1400)
Promotion expense 700
Liability for coupons outstanding 700

Note that the balance of inventory of prize merchandise is 1800 (3200 – 1400) and the
promotional expense for the period is 2100.

7.8 MODEL EXAMINATION QUESTIONS

Part I True or False

___________ 1) Gain contingencies are usually recorded & reported on the financial
statements if probable or reasonable.
___________ 2) A liability is measured as the present value of all future cash payments
are discounted at the interest rate consistent with the risks involved.
__________ 3) All obligations with terms beyond normal trade terms explicitly or
implicitly involve interest.
_________ 4) Short term obligations expected to be refinanced on long term basis are
classified as long-term liabilities.
_________ 5) Stock dividends declared but not distributed to the stock holders are treated
as current liability.
_________ 6) Cash or other assets received in advance for the delivery of goods or
services create liability for receiving firm.
_________ 7) Unless the liabilities are paid as of the balance sheet date, it should not be
recorded regardless of its incurrence or not.

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Part II Multiple Choice
________ 1) A manufacture of household appliances has potential costs due to the
discovery of a possible defect in one of its products. The occurrence of the
costs is reasonably possible and costs can be reasonably estimated. This
possible loss should be:

Accrued Disclosed in Footnotes

A No No
B No Yes
C Yes Yes
D Yes No
________ 2) On Sep. 1 1990 P. Company issued a note payable to national Bank of
Ethiopia in the amount of Br. 1800,000, bearing interest at 12% and
payable in three equal annual principal payments of 600,000. On that date,
the Bank’s interest rate was 11%. The 1 st interest and principal payment
was made on Sep. 1 1991. At Dec. 31, 1991, P. Company should record
accrued interest payable of:
A 44000 C 66000
B 48000 D 72000
________ 3) An expropriation of assets which is imminent and for which the amount of
loss can be reasonably estimated should be:
Accrued Disclosed
A No No
B No Yes
C Yes Yes
D Yes No
_________ 4) When occurrence of a gain contingency is reasonably possible and its
amount can be reasonably possible and reasonably estimated, the gain
contingency should be:

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 A) Included in net income and disclosed
B) Included as a proportion of retained earnings
C) Disclosed, but not included in net income
D) Neither included in net income nor disclosed

Part III Exercise

1. On Jan. 6, 1990 XYZ Company acquired prize merchandise costing Birr 5000 for
distribution in promotional campaign, and related coupon costing Br. 100 (an
immaterial amount). During, 1990 prize merchandise costing Br. 3100 was
distributed to customers in exchanged for coupons. Coupons redeemable for Br.
8000 of prize merchandise were issued to customers. The controller of XYZ
company estimated that 90% of the coupons would be presented by customers
who obtained the coupons from carton’s of XYZ product No. Expiration date
appeared on the coupons.
Required: Prepare journal entries for XYZ Company in relation with the
promotional campaign.

2. ABC car dealer sold a used car (merchandise) with a one-year warranty. The
warranty covers merchandise parts but the customer must pay any labor charges.
Suppose the car was sold on Sep. 1. 19x1 at a sales price of 16,000 cash. Past
experience shows that warranty expense is about 2% of the sales price. Assume
further the customer has a problem with the car and returns it for warranty repairs
on Dec. 10 19x1. The car dealer performs the warranty work by replacing parts
that cost Birr 90 and charges the customer Birr 110 for labor services.

Required
Prepare journal entries for ABC car dealer to record
a) The sale s of the car (as merchandise)
b) The estimated product warranty liability
c) The settlement of warranty obligation

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 d) The customers payment (assume that product liability is recorded at the time
of sale)

3. GTZ Construction Company has a Bonus plan under which a branch manager
receives 20% of the income over Br. 20,000 earned by the branch. Assume, for
the year ended Dec. 31, 19x1, income for the branch amounted to Br. 80,000
before the bonus and Income tax. Determine the bonus under each of the three
plans (assume that Income tax rates are 40% of the profit before tax income).
a) Bonus is based up on earnings before bonus and I/Tax in excess of 20,000
b) Bonus is based up on earnings after bonus but before income tax
c) Bonus is based up on earnings after bonus and income tax

4. Markos company sells appliances service contracts to repair appliances for a two-
year period. Marko’s past experience is that of the total amount spent for repairs
on service contracts, 40% is incurred evenly during the first contract year and
remaining 60% evenly during the second contract year. Receipts from the service
contract sales for the two years ended Dec. 31, 1992 are Br. 500,000 in 1991 and
Br. 600,000 in 1992. Receipts from contract are credited to unearned service
contract revenue. Assume that all contract sales are made evenly during the year,
what amount should Markos Company report as unearned service contract
revenue (liability) at Dec. 31 1992?

5. During a year, a Bus driver stopped the bus suddenly and filed out a suit against
the company for Br. 1000,000. The suit is pending. The company expects to be
held liable and estimates that the final settlements will be between Birr 100,000
and Br. 500,000. What entry, if any, is appropriate?

7.9 GLOSSARY

1. Bonus: conditional payment for achieving results better than usual.

2. Contingency: Uncertainty as to possible gain or loss to a business
enterprise that ultimately will be resolved when a future event occurs or
fails to occur.

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3. Current liability: Obligation for which payment will require the use of
current assets or the creation of other current liabilities in one year or one
operating cycle which ever is longer.
4. Lien date: The date on which the taxes become legal claim against
property until a debt on it is repaid.
5. Refinancing: Replacing short-term debt with either long term debt or
equity securities or renewing, extending or replacing the short term debt
with other short term debt for more than one year from the date of the
balance sheet date.
6. Warranty: An agreement that obligates the seller or manufacturer to
repair or replace a product within a specific period.

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