Final Answer:
The liability is not fixed
The correct option is 1.
Step-by-step explanation:
Accrual accounting requires recognizing expenses when they are incurred and can be reasonably estimated, rather than when cash changes hands. In this scenario, the liability is contingent on a future event, namely an increase in efficiency, which is expected to occur after the end of the year.
Since the liability is not fixed and depends on a future occurrence, Elizabeth cannot recognize any deduction for this contract in year 0. The fundamental principle of accrual accounting is to match expenses with the period in which they are incurred, ensuring a more accurate representation of financial performance.
In accrual accounting, the key criterion for recognizing liabilities is that they must be both probable and estimable. The term "fixed" in this context means that the amount of the liability is reasonably certain. If the liability is contingent on a future event, it fails to meet the criteria for recognition in the current period. Elizabeth must wait until the contingency is resolved, and the liability becomes fixed before recognizing any deduction associated with the contract.
In summary, the disallowance of recognizing a deduction in year 0 for this contract is grounded in the accrual accounting principle that requires fixed and determinable liabilities. The contingent nature of the liability, hinging on a future increase in efficiency, renders it inappropriate for immediate recognition under accrual accounting standards.
The correct option is 1.