On this page (9)
Why this topic matters
This topic combines everyday current liabilities with the judgment-heavy rules for contingencies (Accounting Standards Codification (ASC) 450), guarantees (ASC 460), and asset retirement obligations (ASC 410). Financial Accounting and Reporting (FAR) questions typically give a scenario and ask whether to accrue, disclose, or do nothing — and how much to accrue.
Current liabilities
| Liability | Key rule |
|---|---|
| Accounts payable | Recorded when title passes; gross or net of purchase discounts |
| Notes payable | Short-term notes at face; discounted notes record interest as a discount |
| Accrued liabilities | Wages, interest, utilities, and taxes incurred but unpaid at period-end |
| Unearned revenue (contract liability) | Cash received before performance; recognized as revenue when performance occurs |
| Sales tax and payroll withholdings | Collected for a government — a liability, not revenue or expense |
| Current maturities of long-term debt | Principal due within 12 months |
| Dividends payable | Cash dividends once declared (stock dividends distributable are equity) |
Compensated absences
Accrue a liability for vacation (and similar absences) when all four conditions are met: the obligation relates to services already rendered; rights vest or accumulate; payment is probable; and the amount is reasonably estimable. Non-vesting sick pay generally need not be accrued even if it accumulates.
Gift cards and customer loyalty programs
Gift card sales are contract liabilities. Expected breakage is recognized as revenue in proportion to redemptions when the entity expects to be entitled to it; otherwise when redemption becomes remote. Loyalty points are a separate performance obligation — part of the sale price is deferred.
EXAMPLE: A retailer sells $100,000 of gift cards and expects 10% breakage. During the year $45,000 is redeemed — 50% of the $90,000 expected. Revenue = 45,000 + (10,000 × 50%) = $50,000; remaining contract liability = $50,000.
Loss contingencies (ASC 450)
| Likelihood | Reasonably estimable | Not estimable |
|---|---|---|
| Probable (likely to occur) | Accrue and disclose | Disclose |
| Reasonably possible (more than remote, less than likely) | Disclose | Disclose |
| Remote (slight chance) | No accrual or disclosure (except guarantees) | No accrual or disclosure |
Measuring an accrual
- If one amount in a range is the best estimate, accrue it.
- If no amount in the range is better than any other, accrue the minimum of the range and disclose the possible additional loss.
- International Financial Reporting Standards (IFRS) use the midpoint and a lower "more likely than not" threshold for "probable".
EXAMPLE: Counsel says a loss is probable and will fall between $200,000 and $500,000, with no amount more likely. Accrue $200,000 and disclose that up to $300,000 more is reasonably possible.
Specific situations
- Unasserted claims: disclose only if it is probable a claim will be asserted and an unfavorable outcome is at least reasonably possible.
- General business risks and possible future uninsured losses (for example, no fire insurance) are not accrued — no event has occurred.
- Self-insurance: accrue only for incidents that occurred before the balance sheet date.
- Litigation after year-end from an event before year-end is a recognized subsequent event.
- Environmental remediation is accrued when probable and estimable, measured without offsetting expected insurance recoveries (record recoveries separately when probable).
Gain contingencies
Gain contingencies are not recognized until realized or realizable — even if highly probable, and even if a favorable judgment is on appeal. Disclose them carefully, avoiding misleading implications about likelihood of realization.
COMMON TRAP: A company "virtually certain" to win $1,000,000 in a lawsuit still records nothing. Gains are recognized when the case is settled and the amount is realizable.
Warranties
- Assurance-type warranty (the product works as promised): accrue the estimated cost in the period of sale — debit warranty expense, credit warranty liability. Actual repairs reduce the liability.
- Service-type warranty (extra coverage or separately priced): a separate performance obligation under ASC 606 — defer revenue and recognize it over the coverage period.
EXAMPLE: Sales are $2,000,000 and warranty costs are estimated at 3% of sales. The beginning liability was $20,000 and claims paid were $45,000. Warranty expense = $60,000; ending liability = 20,000 + 60,000 − 45,000 = $35,000.
Guarantees (ASC 460)
A guarantor recognizes, at inception, a liability for the fair value of the obligation to stand ready — even if a payout is remote — and then applies ASC 450 (and the current expected credit loss model where relevant) to the contingent payment. Guarantees are disclosed even when the chance of loss is remote.
Asset retirement obligations (ASC 410)
- Recognize a legal obligation to retire an asset at fair value (usually the present value of expected costs using a credit-adjusted risk-free rate) when incurred.
- Capitalize the same amount into the asset and depreciate it.
- Increase the liability each period through accretion expense (an operating expense, not interest).
- On settlement, any difference between the liability and actual cost is a gain or loss.
Commitments
- Unconditional purchase obligations and other significant commitments are disclosed.
- Losses on firm, non-cancelable purchase commitments are recognized when the market price falls below the contract price.
How it is tested
- Decide accrue / disclose / nothing for a contingency.
- Compute the accrual when a range is given.
- Roll forward a warranty liability.
- Compute gift card revenue including breakage.
EXAM TIP: Build a quick grid in your head: probable + estimable = accrue; anything reasonably possible = disclose; remote = nothing (except guarantees); gains = never accrue.