Accounting for Liabilities, Provisions and Contingencies

Liability
● It is a present obligation of an entity arising from a past event, the settlement of which
is expected to result to an outflow of resources embodying economic benefit.
● Liabilities need not be paid for in cash e.g. provision for depreciation.
● A liability can be in writing and can also be created orally i.e. Constructive obligations.

Obligating Event
● It is an event that creates a legal or constructive obligation that results in an entity no
having any realistic alternative to settling that obligation.

a) Legal Obligation
● It is an obligation that derives from.
i) A contract (i.e. through its implicit or explicit terms)
ii) Legislation
iii) The operation of law.

b) Constructive obligations
It is an obligation that arises from an entity, actions where
i) By an established pattern of practice, published policies or a sufficiently specific
current statement, the entity has indicated to other parties that it will accept certain
responsibilities and;
ii) As a result, the entity has created a valid expectation on the part of those other parties
that it will discharge those responsibilities e.g.

Short –term liabilities

They are also referred to as current liabilities. Examples include
i) Trade payables
ii) Accrued expenses
iii) Incomes in advance (prepared expenses)

1
 iv) Short-term loans
v) Other accounts payables.

Example 1
Albert bought goods on credit on 1st January 2023 for £100,000 and was given the following
terms.
● Trade Discount of 10%
● Cash Discount of 2/10, n/30
Albert settled £50,000, worth goods, on 9th January 2023 and cleared the balance on 30th January
2023

Required
Prepare journal entries in the books of Albert using.
i) Gross method
ii) Net method

Example 2
Patrick bought office equipment on 4th June 2023, on Credit, for £ 50,000 and was given the
following terms:
i) Trade discount of 8%
ii) Cash Discount 3/10, n/30
Patrick settled £20,000 on 12th June 2023 and cleared the balance on 15th June 2023.

Required
Prepare journal entries to record the above transactions in Patrick’s books using
i) Gross Method
ii) Net method

Freight charges
FOB Accounting

2
 ● FOB means Free on Board. It is a term used in shipping (or in most conventional cases,
transportation of goods)
● FOB Accounting deals with the treatment of freight charges and how they are recorded in
the accounting system.

FOB Destination Accounting

● FOB destination is sued to mean that the seller of the goods pays all expenses in putting
the good “on board” the transport and delivering them to the buyer’s premise.
● Once the goods are at the buyer’s premises (or destination), the title of ownership of the
goods and the risk passes to the buyer.
● The buyer now has an obligation to pay for the goods and is responsible for all future
expenses incurred on them.

Example 3 (FOB Destination)

Patrick bought a machine worth £ 10,000 on credit on 1st September 2021. The terms of the
transaction were FOB Destination. Patrick paid for it on 30th September 2021. Freight cost on the
machine was £1,500.

Required
Prepare journal entries in the books of Patrick.

FOB SHIPPING POINT ACCOUNTING

● This is also known as FOB origin.
● It is used to mean that the seller ahs to get the goods to the shipping point, but the buyer
is responsible for the expenses of transporting the goods form the shipping point to their
destination.
● Once the goods are at the shipping point, the title of ownership of the goods and the risk
passes to the buyer.
● The buyer now has an obligation to pay for the goods and responsible for all future
expenses.

3
Example 4 (FOB shipping point)
Mary bought goods worth £8,000 on credit on 2nd June 2023. The terms of the transaction were
FOB shipping point. The freight charges were expected to be £1,500. Mary paid the entire costs
20th June 2023

Required
Prepare journal entries to record the above transactions in the book of Mary.

Example 5 (FOB)
On 1st March 2023, Alex bought a cleaning equipment of £20,000 on credit. Freight cost were
£900. Payments with regard to the item were made by Alex on 25th March, 2023,.

Required
Open journal entries in the books of Alex, assuming that the cleaning equipment was sold on the
following terms.

a) FOB shipping
b) FOB Destination
Equipment was sold on the following terms

a) FOB Shipping
b) FOB Destination

Accounting for Value Added Tax (VAT)

● It is also referred to as sales Tax.

● It is tax levied on goods sold to the consumers. It is computed based on a percentage of
the cost of the goods.
● However, there are goods that the government deems to be VAT free e.g. water or other
essentials.

4
Example 6 (VAT)
Betty Plc. bought goods worth £160,000 on credit on 10th April 2023. The price of the goods was
VAT exclusive and the VAT rate was 16%. Betty paid for the goods on 30th April 2023.
Required
Open Journal entries in the books of Betty PLC.

Example 7 (VAT)
George bought goods worth £116,000 on credit on 10th January 2023. The price of the goods was
VAT inclusive the VAT rate being 16% George paid for the goods on 20th January 2023

Required
Record the above transactions through journal entries in the books of George.

Provisions, Contingent Liabilities & Contingent Assets

Provisions
● A provision is a liability of uncertain timing and / or amount.
● Examples include:
i) Provision for doubtful debts (or allowance for receivables).
ii) Provision for depreciation.
● According to 1AS 37, a provision is only recognized when it fulfills the following three
conditions.
i) P = Presents obligation either legal or constructive as a result of a past event.
ii) P = Probable transfer of economic i.e. to acknowledge that some provision are
not settled in cash e.g. provision for depreciation.
iii) R = Reliable estimate can be made in monetary terms (e.g. in Kshs.).

Alternatively
i) R = Reasonable reliable estimate (in monetary terms).

5
 ii) O = Obligation (i.e. Present legal or constructive obligation).
iii) T = Transfer (i.e. Resources embodying economic benefits are expected to flow out
of the organization in order to settle it.

Contingent Liabilities
● A contingent liability is a failed provision. If any of the above three criteria are not
met, then it is a contingent liability.

a) It is possible obligation (i.e. not a present obligation) that arise from a past event and
whose existence will be confirmed by the occurrence or non-occurrence of one or more
uncertain future events, not wholly within the control of the entity.

b) It is a present obligation that arises from a past event but it is not recognized because.:

i) It is not probable that the outflow of resources embodying economic benefits will
be required to settle the obligation.
ii) The amount of obligation cannot be measured in monetary terms with sufficient
reliability.
An example of a contingent liability is a legal suit.

Contingent Assets

It is possible asset that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the
control of the entity. An example is a legal suit where a firm has sued for damages.

6
Accounting Treatment for Provisions, Contingent liabilities and Contingent assets

1) Provision

If an item meets the three criteria for a provision (1AS 37), then provide of it.

2) Contingent Liabilities

i) If they are certain, then provide for them i.e.

Dr Cr

Contingent expense x

Contingent liability x

ii) If they are probable then provide for them i.e.

Dr Cr
Contingent expense x
Contingent liability x

iii) If they are possible then disclose them in the financial statement by way of notes.

iv) If they are uncertain or remote then IGNORE THEM (i.e. exclude them from the
financial statement).

3) Contingent Assets
i) If they are certain then recognize them in the financial statements as follows.
Dr. Cr.

Cash/Bank x

Contingent Income x

7
 ii) If they are probable then disclose them in the financial statement by way of
notes.
iii) If they are possible then ignore them.
iv) If they are uncertain remove then IGNORE THEM.
Summary

Degree of certainty Contingent liabilities Contingent Assets

Certain Provide for: Recognize

Dr. Contingent expense Dr. Cash/Bank.
Cr. Liability Contingent Cr. Contingent Income

Probable Provide for: Disclose in the financial

statements by way of notes
Dr. Contingent expense
Cr. Liability Contingent

Possible Disclose in the financial IGNORE

statements by way of notes

Remote IGNORE IGNORE

4) Onerous Contracts

It is a contract in which the unavoidable cost of meeting the obligation under the contract
exceed the economic benefits expected to be received under it.

Example 8 (Contingency)

KFC restaurant sold fried chicken to customers in the month of January 2022 The customers
suffered food poisoning and were hospitalized. The customers subsequently sued KFC on 31st
January, 2022 for damages of £50,000. Lawyers of KFC advised them that the case was probably
to be ruled in favor of the customers. The judgment was passed on 12th August 2023 in favor of
the customers whom were awarded £70,000. KFC paid the damages immediately.

8
Required
Record journal entries, for the transactions that occurred on 31st January 2022, and 12th August
2023, in the books of KFC.

Example 9
On 2nd February 2022 St Martins Hospital conducted a surgical operation on a patient and by
error, they stitched the patient with scissors still inside the patient’s body. On 31st March 2022,
the patient sued the hospital for £200,000 as damages for the error they conducted. The hospital
immediately sued the consultant surgeons who were responsible for the operation for £300,000.
The lawyer’s for the hospital advised that both cases were probable. On 31st January 2023, the
judge made a ruling that the hospital should pay damages of £150,000 to the patient while the
surgeons should pay the hospital £220,000. The ruling was honoured by all parties immediately.

Required
Prepare Journal entries in the books of the hospital.

9
Accounting for Warranties and Guarantees
Guarantee
● It is a formal assurance or promise that certain conditions will be fulfilled, especially that
a product will be repaired or replaced if it is not of a specified quality and durability.
(Think: a constructive liability not based on any underlying contract).

Warranty
● A promise made by a buyer to a seller to make good on a deficiency ( e.g. arising due to
an issue on quantity, quality or performance).
● It is a written guarantee promising to repair or place an item or product if necessary
within a specified duration of time. E.g. a written promise to replace a component of an
electronic equipment if it malfunctions within a period of two years from the date of its
acquisition.
● Warranties and Guarantees –arises from an obligation regardless of whether the
promise is formal (i.e. written) or not (i.e substance over form)
● They are usually treated as liabilities that arise due to a legal or constructive
obligation.

Accounting for Warranties (Normal Warranties) & Guarantees

1) When the warrant expense is incurred
Dr. Cr.
£ £
Warranty expense x
Warranty liability x

10
 2) When the actual warranty is determined and payment for it is made.
Dr. Cr.
Warranty liability x
Cash/Bank x
Example 10
Brighton PIC said electronic gadgets of £500,000 in the year ended 1st January 2023. The firm
estimates that 1.5% of the sales will be faulty and therefore is provided for a warranty expense.
After the actual warranty period of 1 year expired, the actual warranties were £8,500 and were
settled immediately.

Required
Prepare journal entries to record the above transactions in the books of Brighton PLC on 1st
January 2023 and 31st December 2023.

Example 11
From the above example on Brighton PLC, assume the actual warranties on 31st December, 2023
were £5,000 and were settled immediately.

Required
Prepare Journal entries in Brighton’s books at 1st January 2023 and 31st December 2023

Example 12
Sales of Duke PLC’s electronic kettles for the years 2021, 2022 and 2023 were £ 1 million,
£1.5million and £2 million respectively. Duke PLC estimates that the warranty expenses will be
2% of the sales. The actual warranty expenses for the years 2021, 2022 and 2023 were £25,000.
£27,000 and £42,000 respectively and they were settled immediately on those dates.

NB: Warranties incurred in a given year were settled in the same year.

11
Required
Open journal entries in the books of Duke PLC and record the above transactions in their
respective years.

Example 13
Rockie sells electronics equipments and had sales as shown below
Year Sales
£ “million”
2021 100
2022 120
2023 160
The firm estimates that warrants will be 5% of its annual sales which are expected to occur as
follows: 3% in the first year of sale and 2% in the second year of sale.

Actual warranties costs amounted to:

Year Actual warranty cost
£”million”
2021 5.5
2022 5.0
2023 8.2
Actual warranty costs were settled immediately.
Required
a) Prepare journal entries to record the transactions in the years 2021, 2022 and 2023.

Accounting for extended Warranties

Extended warranties are agreements to provide warranty protection in addition to the scope of
coverage of the manufacturer’s original warranty if any; or to extend the period of coverage
provided by the manufacturer’s original warranty.

12
Example 14 (Extended Warranties)
IKEA UK sold 500 units of leather sofas in cash on 2nd January, 2020, for £1,000 each. The
leather sofas had a normal warranty period of warranties for an extra period of 2 years for £100
each. Out of the 500 units of leather sofas sold, 200 of them were sold with extended warranties.

Required
a) Assuming there weren’t any defective units of leather sofas sold by IKEA UK, prepare
journal entries to record the above transaction in its book for the four years.

Example 15
From the example above (on IKEA UK), suppose the actual warranty for the extended warrant
period amounted to £7,000 and £8,000 respectively. These extended warranties were settled
immediately.

Required
Prepare journal entries to record the transactions above for the four years.

13