4/22/2020

GODFREY
HODGSON
HOLMES
TARCA

CHAPTER 8
LIABILITIES

INTRODUCTION

1.What is liability and What are the

characteristics of liability
2.What is: a. Legal obligation b. Constructive
Obligations
3.How is liability measured and recognized
4.What is Provision and Contingence
5.What is Off-balance sheet financing
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LIABILITIES DEFINED

IASB definition of IASB NEW VERSION:

LIABILITIES (OLD VERSION):
A present obligation of the
entity arising from past
events, the settlement of
which is expected to result in
an outflow from the entity of
resources embodying
economic benefits
A present obligation
of the entity to
transfer an economic
resource as a result of
past events
economic resource is defined
as a right that has the potential
to produce economic benefits
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LIABILITIES DEFINED
• FASB:
– Liabilities = Probable future sacrifices of economic
benefits arising from present obligations of a particular
entity to transfer assets or provide services to other
entities in the future as a result of past transactions or
events
• Characteristics of LIABILITY:
– Present Obligation
– Outflow of resources
– Past Transaction/Events

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C1:Present obligation

• The actual sacrifices are yet to be made

• Obligation is already present (31 Dec 20XX)
• Involves an external party
• Legal enforceability
• Settlement of liability in various ways

C2: Outflow of resources

• There should be outflow of resources
• The outflow of resources & other events must
be probable (i.e. more than 50% probable)
• Level of probability in accounting:

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C3: Past transaction

• A past transaction (or event) ensures that only

present liabilities are recorded and not future
ones
• Acceptable past transaction or event:
Legal obligation
 Constructive obligation
 What about Executory contracts?
Not liability A signed long-term Contract but
not yet been fully performed or
fully executed 7

LEGAL AND CONSTRUCTIVE

OBLIGATIONS
• Legal obligation = • Constructive obligation =
an obligation that
derives from:
– A contract (through its
explicit or implicit
terms); or
– Legislation; or
– Other operation of
law
an obligation that derives
from an entity’s action
where:
– Past practice, published
policies or sufficiently specific
current statement,
responsibilities;
– As a result, the entity will
discharge its responsibilities to
other parties

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LIABILITY RECOGNITION

Recognition criteria:
• Reliance on the law
– legal enforceability
• Determination of the economic substance of
the event (‘real’ obligation):
– Definition of liability
– Measurable

LIABILITY RECOGNITION
Recognition criteria:
• Ability to measure the value of the liability
– normally the nominal amount
– if period longer than 12-months, based on the present
value of expected future cash flows
• Use of the conservatism principle
– Recognise liability as soon as possible as long as it is
probable and measurable
– Does not wait its realisation
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IASB Framework

• A liability should be recognised if

it is probable that
any future the item has a cost
economic benefit or value that can be
associated with the measured with
items will flow to or reliability
from the entity;

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Liability measurement (IASB)

• Under IFRS, historical cost is the most

common
• Fair value measurement is more commonly
being used for:
– leases
– financial instruments
– share based payments
– business combinations

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PROVISION AND
CONTINGENCY

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PROVISION

• Provisions and contingencies occur where

there is a blurring between present and
future obligations
• Provisions = a special category of liabilities =
liabilities of uncertain timing and amount
– There must be a clear present obligation from a
past obligating event

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PROVISION

LIABILITIES of uncertain timing and amount

Present obligation of entity outflow of resources

arising from PAST EVENTS (economic benefits)

Legal Constructive
obligation obligation

Liability vs Provision

• A known amount • A liability of uncertain

• Present obligation of entity
arising from past events
• Result in outflow of
resources
• Recognize as and when the
liability arises
• Example: Trade Payable,
Accrued Salary etc
• Recognize when it meets
the recognition criteria
• Example: Guarantees
(product warranties),
Pension

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Provisions - Recognition

PRESENT PROBABLE
OUTFLOW OF RELIABLE ESTIMATE
OBLIGATION (MEASUREMENT)
RESOURCES
• Present obligation must • There should be
have been arise from the • The outflow
outflow of resources
past event should have
• The outflow of
• Determine present reliable estimate
resources & other
obligation at the end of • This would be
events must
reporting period using: extreme rare case
be probable (i.e.
• Expert opinion where no reliable
more than 50%
• Evidence provided by estimate can be
probable)
IAS 10: Event after made
the reporting period

PROVISION

• If just one of them is not met, then we

should either:
Disclose Do nothing if
a contingent OR the outflow of
liability (read economic
more about it benefits is
next section), remote.

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PROVISION
When to recognize a provision?

Can we AVOID the obligation by our future action?

Do not Recognize a
recognize a provision provision
Examples:
Training of personnel Warranty Repairs

PROVISION-Measurement

• Best estimate at balance sheet date of

amount needed to settle obligation
• Considers:
• Risks and uncertainties (like inflation),
• Time value of money (discounting when
the settlement is expected in the long-
term future)
• Some probable future events, etc

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methods of measuring a
provision
• Expected value method:
– use this method when we have a range of possible
outcomes or we measure the provision for large amount of
items.
– In this case, we need to weight each outcome by its
probability (for example, warranty repair costs for 10 000
products).
• The most likely outcome:
– suitable in the case of a single obligation or just 1 item (for
example, provision for loss in the court case).

How to account for a provision?

>12 month, use PV

insurance
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Provisions in specific
circumstances
1. Future operating losses

No provision

The future operating losses

Because there is no
can be avoided by some
past event
future actions

example – by selling a business

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Provisions in specific
circumstances
a contract in which
2. Onerous contracts unavoidable costs of
fulfilling exceed the
benefits from the contract
Loss of contract
Unavoidable
costs of fulfilling
the contract
PROVISION
Lower of
Penalty for not
meeting
obligations from
the contract
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Provisions in specific
circumstances
A program planned &
3. Restructuring controlled by management
that change the scope of
business or a manner of
A PROVISION conducting a business

detailed formal plan for restructuring

If, there is with relevant information (about
business, location, employees, time
schedule and expenditures)

valid expectation related to restructuring has

been raised in the affected parties
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Disclosures - Provisions

• Key disclosures required:

– Accounting policies for each major type
of provision (for example, warranties)
– Movements in provisions during the
period
– Descriptions of contingent liabilities and
contingent assets

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CONTINGENT LIABILITIES
• Contingent liabilities =
– Possible obligations that arise 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
– because:
• It is not probable that an outflow of resources embodying
economic benefits or service potential will be required to settle
the obligation; or
• The amount of the obligation cannot be measured with
sufficient reliability

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Contingent liabilities
• For example, We might face a lawsuit, but our
lawyers estimate the probability of losing the case at
30% – in this case, it’s not probable that we will have
to incur any expenditures to settle the claim and we
should not book a provision. It’s typical contingent
liability.
• If we identify we have a contingent liability, we do
NOT recognize it – no journal entry.
– only make appropriate disclosures in the notes to
the financial statements.
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Contingent assets

• A contingent asset = a possible asset arising

from past events that will be confirmed by
some future events not fully under the entity’s
control.
• Similarly as with contingent liabilities
– Do not recognize contingent assets,
– Only make appropriate disclosures.

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Issues for auditors

• The completeness of liabilities recognised on
the balance sheet and the note disclosures
about contingencies and other obligations are
major issues for auditors
– evidence, timing, cut off
– concealment and understatement
– going concern
– overstatement - provisions
– reasonableness of fair values
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Off-Balance sheet

• Off-balance sheet (OBS) = an accounting practice

by which a company does not include a liability
on its balance sheet
– these items are nevertheless assets and liabilities
of the company.
• Why OBS?
– to keep debt-to-equity (D/E) and leverage
ratios low,
• Ex: Operating Lease & Leaseback agreement
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Summary

• There are definitions for both liabilities and equity

• There are recognition criteria for both liabilities and
equity
• There are various measurement practices used in
relation to liabilities and equity
• There are challenging issues for standard setters and
auditors

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Key terms and concepts

• Liabilities
• Definitions
• Recognition criteria – probable, reliable
• Present obligation
• Past transaction
• Measurement and fair value
• Provisions and contingencies
• Issues for auditors

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