Question

The Conceptual Framework defines liabilities and outlines a number of criteria for their recognition. a-Forden and a-Holden Custom Cars Ltd identifies the following items:

(a) Purchased tyres, glass and steel on account.

(b) Received $100 000 in deposits for custom cars to be built in the next financial period.

(c) Employed two new staff members and agreed to pay them $75 000 per annum. They begin work next week.

(d) One of a-Forden and a-Holden Custom Cars Ltd’s customers is suing the company as he is not happy with the colour scheme the company used to paint the custom car. The customer chose the colour scheme at the time of signing the contract and has now changed his mind. The lawsuit is for $15 000. a-Forden and a-Holden Custom Cars believe they might lose the case.

(e) When constructing a car in the factory, one of a-Forden and a-Holden Custom Cars Ltd’s employees dumped excess paint and other waste products into the local river running behind the factory. The company has been ordered by the court to pay damages; however, the exact amount is yet to be determined.

Required:

For each of the items listed above, explain whether you would recognise it as a liability in the statement of financial position. Refer to the definition and recognition criteria outlined in the Conceptual Framework to support your answer.

Answer 1

(a) Yes, Liability would be recognized as the tyres, glass and steel are already purchased on account and therefore, Purchases account being expense account is debited and Accounts Payable is recorded as the liability and thus, credited.

(b) Yes, liability would be recorded as revenues are received in advance from customers against the future deliveries of custom cars. Since the amount is received, therefore, it will be recorded as per the concept of Unearned Revenue and shown in the balance sheet as liability. Cash or Bank account will be debited as the amount has been received and Unearned revenue or Advance from customers will be credited being the liability account.

(c) No, liability would not be recorded. Salaries to staff is generally recorded on accrual basis and as given that staff will start working next week, therefore, no salaries are accrued to them. Therefore, no entry will be recorded.

(d) Yes, liability would be recorded. Generally court cases are recorded as contingent liability. However, in this case company assumes that they might lose therefore, as per the principle of contingent liabilities, any potential liability which may occur due to happening of any future uncertain event. However, in this case, event is certain as the company has assumed that they might lose. Therefore, it will be recorded as liability.

(e) No, liability would not be recorded as future event is uncertain and amount is also not known, therefore, liability would not be recorded until determination of amount.

I hope above answer will help you in your task.