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Liabilities & Contingencies: Entries, Disclosures & Treatment

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we will discuss liabilities and contingencies. More specifically, we'll go over the journal entries to record them, and the disclosure requirements in the financial statements.

Example of a Liability

Imagine you and your brother are walking through a park. Suddenly you get hit by a competitive urge. You turn to him and say, ''You see that lamppost about 100 yards ahead of us? I bet I can beat you there. In fact, I am so confident, I will bet you $100.''

Your brother looks at the distance, and then replies, ''You have got yourself a bet. 3…2….1….Go.''

Unfortunately, you overestimated your own abilities and the impact your jeans would have on your ability to ''hit your stride.'' You lost and it wasn't even close. You now have the unfortunate obligation of paying your brother. This is called a liability.

Say you hadn't decided on the amount the winner would get, but it could be reasonably estimated that it would be around $100. And although you hadn't raced yet, let's say it was probable that your brother would win. If that was the case, before the race happened, you'd have a specific type of liability - called a loss contingency.

In this lesson, we'll dive into more detail about both liabilities and loss contingencies. We'll define each term, give examples and show how the journal entries should be performed. 3….2….1…GO!

Current and Non-current Liabilities

A liability is a future sacrifice of economic benefit that arises from a past transaction or event. In plain English, a liability is something you or another entity owes another party.

In the example above you have a liability because you need to pay your brother $100 in the future. Just a quick glance on the balance sheet of any public-traded company will show that there are various liability accounts.

First, liabilities (like assets) are organized into current or non-current based on when the obligation needs to be paid. If the obligation will be paid within 1 year, or within the completion of one operating cycle, then the liability is included as a current liability, otherwise it is recorded as a non-current liability.

The major types of current liabilities include:

  • accounts payable
  • accrued expenses
  • loans and notes payable
  • current maturities of long-term debt
  • accrued income taxes.

Non-current liabilities include long-term debt, other liabilities, and deferred income taxes.

Journal Entries

To record the journal entry for a liability, the accountant needs to credit the liability account, which increases total liabilities.

For example, let's use the example of the race with your brother and assume that you did not pay him immediately after the race. If that happened, then you have a liability because you owe him money (if you had paid him right then after the race, then there would be no liability).

To record a liability, we debit liability expense (i.e. Bet Expense) because of an accounting concept called the matching principle, which states we must record an expense as it is incurred. Well, once you lost the bet, the expense was incurred. Bet expense is debited, and Bet Payable (our liability account) is credited (i.e. increased).

Debit Credit
Bet Expense $100
Bet Payable $100

Impact on the income statement: the bet expense is recorded, reducing net income by that amount.

Impact on the balance sheet: an increase in bet payable increases total liabilities, and the bet expense lowers net income, which lowers retained earnings.

Impact on the cash flow statement: no cash changes hands, so there is no impact on the cash flow statement.

As soon as you have the money, and you pay your brother, you need to reduce the liability. To do that you debit the liability and you credit cash. Notice how the treatment of the liability is the opposite of how you recorded it before. You are in essence reversing the journal entry, to wipe it out.

Debit Credit
Bet Payable $100
Cash $100

Contingencies

A loss contingency is when the future outcome is most likely to result in a liability. Examples of common loss contingencies include a lawsuit, a product recall, an environmental spill, or, like mentioned above, a bad bet.

For contingencies to be recorded, wording is very important. To be recorded on the balance sheet, the likelihood of the loss needs to be probable and the amount of the future payment needs to be known.

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