Chapter 26 – Introduction to Liabilities

Liabilities – are present obligation of an entity arising from past events or transactions, the settlement of w/c is
expected to result in an outflow from the entity of resources embodying economic benefits.

Elements in the definition of liability

1. liability is a present obligation of an entity – the entity liable should acknowledge its existing obligation to a particular
payee, whether the latter is identified or not.
- an obligation is a duty or responsibility to act or perform in a certain way. This may be legally enforceable as a
consequence of a binding contract or statutory requirement.

2. liability arises from past transactions or events

- a transaction or event that will give rise to a liability should occur prior to the recognition of an item as liability.
- the past event that gave rise to the present obligating event. An obligating event creates a legal or constructive
obligation because the entity has no realistic alternative but to settle obligation.

Legal obligation vs. Constructive obligation

Legal Constructive
An obligation arising from An obligation that is derived from an entity’s actions
a. Contract where:
b. Legislation; or a. the entity indicated to other parties that it will
c. Other operations of law. accept certain responsibilities by reason of an
established pattern of past practice, published policy,
or a sufficiently current statement.

b. and as a result, the entity has created a valid

expectation on the part of other parties that it will
discharge those responsibilities.

3. the settlement of liability requires an outflow of resources embodying economic benefits.

- settlement of present obligation normally results in giving up resources embodying economic benefits in order to
satisfy the claim of the other party.

Settlement may occur in a number of ways, for example, by:

a. payment of cash;
b. transfer of other assets;
c. provision of services;
d. replacement of that obligation w/ another obligation; or
e. conversion of the obligation to equity.
However, an obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights.

INITIAL RECOGNITION OF LIABILITIES

A liability is recognized in the statement of financial position when
a. it is probable that an outflow of resources embodying economic benefits will result from the settlement of present
obligations; and
b. the amount at w/c the settlement will take place can be measured reliably.

Under PFRS 9, financial liabilities are recognized on the Statement of Financial Position when the entity becomes party
to the contractual provisions of the instrument.
Financial v. Non-financial liabilities
To appropriately assign peso amount to an item classified as liability, liabilities shall be categorized as to either financial
or non-financial liability.

A financial liability is any liability that is;

a. a contractual obligation:
i. to deliver cash or other financial asset to another entity; or
ii. to exchange financial assets or financial liabilities w/ another entity under conditions that are potentially unfavorable
to the entity; or

b. a contract that will or may be settled in the entity’s own equity instruments and is:
i. a non-derivative for w/c the entity is or may be obliged to deliver a variable number of the entity’s own equity
instruments; or
ii. a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments.
**other liabilities that did not meet the above requirements are non-financial liabilities.

CLASSIFICATION OF FINANCIAL LIABILITIES

Financial liabilities are classified as:
1. financial liabilities at amortized cost
2. financial liabilities at fair value through profit or loss
a. designated financial liabilities at FVTPL
b. held for trading
3. financial liabilities that arise when a transfer of financial asset does not qualify for derecognition or when the
continuing involvement approach applies
4. financial guarantee contracts and commitments

Measurement of financial and non-financial liabilities with available fair value

Financial liabilities
Nonfinancial liabilities
Initial Measurement Subsequent measurement
Either: Either:
 Fair value  Fair value
 Fair value minus  Amortized cost
transaction cost
Either: Either:
 Best estimate or amounts  Best estimate or amounts
needed to state the needed to state the
obligations, or obligations, or
 Measurement basis  Measurement basis
required by specific PFRS required by specific PFRS

Definition of relevant terms

Fair value – this is the price that would be received to sell an asset or paid to transfer liability in an orderly transaction
between market participants at the measurement date.

Transaction costs – are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial
liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed
of the financial liability.
Includes:
- Fees and commissions paid to agents, advisers, brokers and dealers
- levies by regulatory agencies and securities exchange
- transfer taxes and duties
Important notes:
For financial liabilities classified at fair value through profit or loss, the following are made:
1. measured at fair value
2. transaction costs are recognized as expense; and
3. changes in fair values are recognized in profit or loss

Non-availability of fair value for financial liabilities

For liabilities in the absence of a quotation in a market, face amount and present value of related cash flows may be
used as basis in determining fair value.

Short-term liabilities are normally measured at face amount.

On the other hand, long-term liabilities shall be valued as follows:

Category Characteristics Measurement
Interest bearing liabilities  Nominal interest rate is  Face amount
not substantially different
with market rate
 Nominal interest rate is  Present value of principal
substantially different w/ and interest payments
market rate
Non-interest bearing liabilities Long-term liabilities (maturity of Present value of principal
more than 12 months) payments
Note: for problem solving purposes, if the problem indicates information that will enable you to compute for present
value of all payments, the appropriate initial measurement would be its present value (short-term payables w/ no stated
interest rates can be measured at invoice amounts when the effect of discounting is immaterial.)

RECLASSIFICATION OF FINANCIAL LIABILITIES

PFRS 9, states that an entity shall not reclassify a financial liability.

DERECOGNOTION OF LIABILITIES
Financial liability is derecognized when extinguished
a. the obligation specified in the contract is discharged, cancelled or it expires
b. an exchange between an existing borrower and lender of debt instruments w/ substantially different terms or
substantial modification of the terms of an existing financial liability of part thereof.

Gain or loss on derecognition – the difference between the carrying amount of a financial liability extinguished or
transferred to a 3rd party and the consideration paid is recognized in profit or loss.

FINANCIAL STATEMENT PRESENTATION

Current liabilities – a liability is classified as current if:
 It is expected to be settled within the entity’s normal operating cycle
 It is expected to be settled w/in 12 months
 It is held for trading
 The entity has no unconditional right to defer payment for at least 12 months from the reporting date
Non-current liabilities are items:
 Other than current liabilities
 Specifically required by particular standard to be classified in this category
Current Liabilities in the Statement of Financial Position
Under PAS 1, as a minimum, the face of the Statement of Financial Position should include the following line items for
current liabilities:
a. trade and other payables
b. current provisions
c. short-term borrowing
d. current portion of long-term debt
e. current tax liability
*additional items shall be presented on the face of the Statement of Financial Position when such presentation is
relevant to an understanding of the entity’s financial position

CLASSIFICATION OF LONG-TERM DEBT FALLING DUE WITHIN ONE YEAR

Settlement and Refinancing
Original term of a period longer To be settled on maturity date
than 12 months
Current
The debtor has the discretion to Noncurrent
refinance for a period of at least 12
months from the reporting date
To be refinanced AFTER the *Current
reporting date or for a period less
than 12 months from the reporting
date
To be refinanced ON OR BEFORE Noncurrent
the reporting date for a period of
at least 12 months from the
reporting date

Breach of provision of loan arrangement

Presence of breach of covenant/s
*Note: qualify for disclosure as non-adjusting events
Required to be settled w/in 12 Current
months
A grace period was granted AFTER *Current
the reporting date or for a period
less than 12 months from reporting
date
A grace period was granted ON OR Noncurrent
BEFORE the reporting date for a
period of at least 12 months from
the reporting date

TRADE ACCOUNTS PAYABLE

Characteristics
Description Present obligations that are not supported by formal promises to pay by the
debtor. These obligations normally arise from acquisitions of inventories to be
used in the normal operating cycle of the entity.
Recognition When ownership of goods are transferred to the buyer
Measurement Fair value, w/c is normally the invoice price of goods acquired and may or may
not be affected by related freight and cash discounts
Presentation Normally included in the current liabilities section under the heading “Trading
and other payables”
Initial Measurement
List or quoted price xx
Less: trade discounts, rebates and other similar items xx
Initial measurement (gross method of recording purchases) xx
Less: purchase discount xx
Initial measurement (net method of recording purchases, whether discount is taken or not) xx

ESTIMATED LIABILITIES – are items that involve a present obligation and satisfy the rest of the definition but can only be
measured only by using substantial degree of estimation.

BONUS PAYABLE – is a gratuity by entities to their employees as a gift or compensation earned as reward upon achieving
a goal such as exceeding budgeted income during the year, meeting quotas, and having a superior performance in a
project or activity. The primary purpose of this is to encourage performance from officers and employees by directly
associating their success to company’s success.

Bonus calculation
1. NI before bonus and tax  B = NY x BR
2. NI after bonus but before tax  B = BR x (NY-B) OR B = BR X NY/100% + BR
3. NI after bonus and tax  B = BR X (NY-B-T) T = TR X (NY-B)
4. NI after tax but before bonus  B = BR x (NY-T) T = TR x (NY-B)
Where:
NY = Net income before bonus and tax
B = Bonus
BR = Bonus Rate
T = Tax
TR = Tax Rate

UNEARNED OR DEFFERED REVENUE – this represents income already collected but not yet earned. This item shall be
presented as part of entity’s liabilities and normally classified as current liabilities. Example include advances received
from customers for goods yet to be delivered, services yet to be provided, gift certificates sold and subscriptions.

DEPOSITS RECEIVED – represent cash received and held in behalf of other entities such as clients and customers. These
items are recognized as liabilities and classified as to either current or non-current depending their settlement dates.
Examples include deposit in escrow accounts and refundable deposits on returnable containers.

Other Examples of Deposit Received and Their Corresponding Accounting Treatment

1. Security deposits received from lessee in a lease agreement
a. if the deposit is refundable, the amount shall be recognized as liability and its classification as to either current or non-
current will be dependent on its settlement date.
b. if the deposit is non-refundable, the amount shall be recognized as liability and will be recognized as income over the
term of the lease.

2. Deposits received from shareholders for future subscription

The deposit shall be presented as a line item in shareholder’s equity
PROVISION AND CONTINGENT LIABILITY
A provision is a liability of uncertain amount or uncertain timing. Provisions are actually estimated liability.

A provision is recognized when:

a. an entity has a present obligation (legal or constructive) as a result of a past event;
b. it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
c. a reliable estimate can be made of the amount of the obligation

A contingent liability is:

a. a possible obligation 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 or
b. a present obligation that arises from past events but is not recognized because:
i. it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
ii. the amount of the obligation cannot be measured w/ sufficient reliability

Relationship between provision and contingent liability

In general sense, all provisions are contingent because they are uncertain in timing or amount. The term “contingent” is
used for items that are not recognized because their existence will be confirmed by occurrence or non-occurrence of one
or more uncertain future events not w/in the control of the entity.

The “contingent liability” is used for liabilities that do not meet the recognition criteria.

Provision vs. contingent liability

Provision Contingent liability
 A present obligation  A possible obligation
 Both probable and reliably measurable  A present obligation w/c is either probable or
 Recognized as a regular liability in the reliably measurable but not both
financial statements  Disclosed in the notes to financial statements
and not recognized in the financial
statements

Likelihood of occurrence Meaning

Probable The future event is more likely than not to occur (i.e.
the probability that the event will occur is greater
than the probability that it will not)
Reasonably possible The future event is less likely to occur
Remote The future event is least likely to occur

Measurement of provision
The amount recognized as a provision shall be the best estimate of the expenditure required to settle the present
obligation at the end of the reporting period. Best estimate is determined as follows:
a. the estimates of outcome and financial effect are determined by the judgement of the management of the entity,
supplemented by experience of similar transactions and, in some cases, reports from independent experts.
b. where the provision being measured involves a large population of items, the obligation is estimated by weighting all
possible outcomes by their associated probabilities. The name for this statistical method of estimation is “expected
value”.
c. where there is a continuous range of possible outcomes and each point in that range is as likely as any other, the mid-
point of the range is used.
Consideration in determining best estimate
In reaching its best estimate, the entity should take into account the following:
1. Risks and uncertainties that surround the underlying events
2. Future events
a. forecast reasonable changes in applying existing technology
b. ignore possible gains on sale of assets
c. consider changes in legislation only if virtually certain to be enacted
3. discounted present value using pre-tax discount rate that reflects the current market assessments of the time value of
money and the risks specific to the liability
4. reimbursement by another party
If some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the
reimbursement should be recognized as a separate asset provided it is virtually certain that reimbursement will be
received if the entity settles the obligation.

The amount recognized as an asset should not exceed the amount of the provision and it should not be treated as a
reduction of the required provision.

5. Gains on expected disposal of assets – an entity recognizes gains on expected disposals of assets at the time of
disposition of assets
6. Presence of onerous contracts – if an entity has an onerous contract, the present obligation under the contract shall be
recognized and measured as a provision.
7. Remeasurement of provisions – the following shall be performed when measuring provisions subsequent to initial
recognition.
a. review and adjust provisions at each reporting date
b. if an outflow no longer probable, provision is reversed.
8. Use of provisions – if it is no longer probable that an outflow of resources will be required to settle the obligation, the
provision should be reversed.

Examples of Provision
Circumstance
Restructuring by sale of an
operation
Restructuring by closure or
reorganization
Warranty
Land contamination
Customer refunds
Offshore oil rig must be
removed and sea bed
restored
Abandoned leasehold, four
years to run, no re-letting
possible
Onerous (loss-making)
contract
Self-insured restaurant,
people were poisoned,
Recognize a provision?
Only when the entity is committed to a sale, i.e. there is a binding sale
agreement
Only when a detailed form plan is in place and the entity has started to
implement the plan or announced its main features to those affected. A Board
decision is insufficient.
When an obligating event occurs (sale of product w/ warranty and probable
warranty claims will be made)
A provision is recognized as contamination occurs for any legal obligations of
clean up, or for constructive obligations of the company’s published policy is to
clean up even if there is no legal requirement to do so (past event is the
contamination and public expectation created by the company’s policy)
Recognized a provision if the entity’s established policy is to give refunds (past
event is the sale of the product together w/ the customer’s expectation, at the
time of purchase, that a refund would be available)
Recognize a provision for removal costs arising from the construction of the oil
rig as it is constructed, and add to the cost of the asset. Obligations arising
from the production of oil are recognized as the production occurs
A provision is recognized for the unavoidable lease payments
Recognize a provision
Accrue a provision (the past event is the injury to customer)
 lawsuits are expected but
none has been filed yet.
A chain of retail stores is self-
insured for fire loss
CPA firm must staff training
for recent changes in tax law
Major overhaul for repairs
Future oprating losses
No provision until an actual fire (no past event)
No provision is recognized (there is no obligation to provide the training,
recognized a liability if and when the retraining occurs)
No provision is recognized (no obligation)
No provision is recognized (no obligation)

ESTIMATED LIABILITIES – AFTER SALE TRANSACTIONS

Liabilities may also arise after recognition of revenue from sale transactions. These liabilities may include, but not limited
to the following:
a. Premiums liability
b. Rebates liability
c. Warranties liability

Premiums liability – premiums are articles offered free or at a reduced price to make a combined offer more attractive to
the customers. In some cases, cash payments are also given to customers as a result of past sales promotional activities.

Rebates liability
Pro-forma journal entries:
1. To recognized provision for rebates to entitled customers:
Rebates Expense XX
Rebates Liability XX
2. To record distribution of rebates to customers
Rebates liability XX
Cash XX

WARRANTY LIABILITY
Warranty is a legally binding assurance that a product is, among other things
 Fit for use as presented
 Free from defective material and workmanship
 Meets statutory and/or other specifications

A warranty that describes the conditions under, and period during, w/c the producer or vendor will repair, replace, or
other compensate for, the defective item w/o cost to the buyer or user. Often it also delineates the rights and obligations
of both parties in case of a claim or dispute.

Warranty is recorded at the time of sale based on best estimate. Estimate is reviewed at a certain date and difference
between estimate and actual cost is accounted as change in accounting estimate to be treated as currently and
prospectively.