COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic: INTERMEDIATE ACCOUNTING 2

Learning Objectives:

1. The student is expected to have a clear picture of the course perspective with proper awareness
of the coverage of the course;
2. Know the recognition criteria for liabilities and their essential characteristics;
3. Identify the characteristics of a financial liability;
4. Know the initial and subsequent measurements of financial and non-financial liabilities;
5. Know how to classify liabilities as current and noncurrent.

Definition (Conceptual Framework, PAS 37)

“Liabilities are present obligations of an entity arising from past transactions or events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits.”

The essential characteristics of an accounting liability are:

a. The liability is the present obligation of a particular entity.

b. The liability arises from past event.
c. The settlement of the liability requires an outflow of resources.

Present Obligation

An essential characteristic of a liability is that the entity has a present obligation. The present obligation may
be a LEGAL obligation or a CONSTRUCTIVE obligation.

Obligations may be legally enforceable as a consequence of binding contract or statutory requirement.

e.g. amounts payable for goods and services rendered

Constructive obligation arises from the entity’s actions, through which it has indicated to others that it will
accept certain responsibilities, and as a result has created an expectation that it will discharge those
responsibilities.

e.g. warranty obligations

Past Event

Another essential characteristic of a liability is that the liability must arise from a past transaction or event.

The past event that leads to a legal or constructive obligation is known as the obligating event.

The obligating event creates a present obligation because the entity has no realistic alternative but to settle the
obligation created by the event.

e.g. “The acquisition of goods gives rise to accounts payable.”

Obligating Event

Outflow of future economic benefits

The settlement of a liability usually involves the entity transferring resources embodying economic benefits in
order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways,
for example, by:

• payment of cash;
• transfer of other assets;
• provision of services;
• replacement of that obligation with another obligation; or
• conversion of the obligation to equity.
Examples of Liabilities:

1. Accounts payable to suppliers for the purchase of goods or services.

2. Amounts withheld from employees or other parties for taxes and for contributions to the Philhealth,
HDMF, Social Security System or pension funds.
3. Accrual for wages, interest, royalties, taxes, product warranties and profit-sharing plans
4. Dividends (not stock dividends) declared but not paid
5. Deposits and advances from customers and officers
6. Debt obligations for borrowed funds – notes, mortgages, and bonds payable
7. Income tax payable
8. Unearned Revenue

INITIAL MEASUREMENT OF LIABILITIES

PFRS 9 requires an entity to recognize a financial liability in its statement of financial position when it becomes
party to the contractual provisions of the instrument. At initial recognition, an entity measures a financial
liability at its fair value minus, in the case of a financial liability not at fair value through profit or loss,
transaction costs that are directly attributable to the issue of the financial liability.

Transaction costs are included in the initial measurement of a liability measured at amortized cost.

Transaction costs are expensed immediately if the financial liability is designated initially as at fair value
through profit or loss.

Transaction costs do not

Transaction costs are incremental costs that Transaction costs include
include
are directly attributable to the issue of a financial Fees and commissions paid to
Debt premiums or discounts
liability. An incremental cost is one that would agents, brokers, dealers, etc.
not have been incurred if the entity had not Levies by regulatory agencies
Financing costs
and security exchange
issued a financial liability. Internal administrative or
Transfer taxes and duties
holding costs

Fair value of a financial liability (under PFRS 13) is the amount that would be paid to transfer a liability in
an orderly transaction between market participants at the measurement date.

Conceptually, the fair value of the liability is equal to the present value of the future cash payment to settle the
obligation. The term “present value” is the discounted amount of the future cash outflow in settling an
obligation using the market rate of interest.

SUBSEQUENT MEASUREMENT OF LIABILITIES

PFRS 9 provides that after initial recognition, an entity shall measure the financial liability:

a. At amortized cost, using the effective interest rate

b. At fair value through profit or loss

The amortized cost of a financial liability is the amount at which the financial liability is measured at initial
recognition minus principal repayment, plus or minus the cumulative amortization using effective interest
method of any difference between the initial amount and the maturity amount.

Simply stated, the difference between the face amount and present value of the financial liability is amortized
through interest expense using the effective interest method.

Actually, the difference between the face amount and present value is either discount or premium on the issue
of financial liability.
Fair value option of measuring financial liability

PFRS 9, provides that at initial recognition an entity may irrevocably designate a financial liability at fair value
through profit or loss when doing so results in more relevant information.

In other words, under the fair value option, the financial liability is measured at fair value at every year end and
any change in far value is recognized in profit or loss. The interest expense is recognized using nominal or
stated rate.

CLASSIFICATION OF LIABILITIES

Under PAS 1 on presentation of financial statements, liabilities are classified into two, namely:

1. Current Liabilities
2. Noncurrent Liabilities

Current Liabilities – an entity shall classify a liability as current when it satisfies any of the following:

a. The entity expects to settle the liability within the entity’s operating cycle.
b. The entity holds the liability primarily for the purpose of trading.
c. The liability is due to be settled within 12 months after the reporting period.
d. The entity does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting period.

When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be twelve months.

Conceptually, all liabilities are initially measured at present value and subsequently measured at amortized
cost. However, in practice, current liabilities or short-term obligations are not discounted anymore but
measured and recorded at face amount.

Noncurrent Liabilities - liabilities that are due after a year or more. Noncurrent liabilities include:

a. Noncurrent portion of long-term debt

b. Finance lease liability
c. Deferred tax liability
d. Long-term obligation to entity officers
e. Long-term deferred revenue

Long-term debt falling due within one year

A liability which is due to be settled within twelve months after the reporting period is classified as current,
even if:

1. The original term was for a period longer than twelve months
2. An agreement to refinance or to reschedule payment on a long-term basis is completed after the
reporting period and before the financial statements are authorized for issue.

However, if the refinancing on a long-term basis is completed on or before the end of the reporting
period, the refinancing is an adjusting event and therefore the obligation is classified as noncurrent.

Moreover, if the entity has the discretion to refinance or roll over an obligation for at least 12 months
after the reporting period under an existing loan facility, the obligation is classified as noncurrent even if
it would otherwise be due within a shorter period.

If the entity has an unconditional right under the existing loan facility to defer settlement of the liability
for at least 12 months after the reporting period, the obligation is classified as noncurrent.
 Breach of Covenants

If certain conditions relating to the borrower’s financial situation are breached, the liability becomes
payable on demand.

Non-adjusting events

With respect to loans classified as current liabilities, the following events occurring between the end of
reporting period and the date the financial statements are authorized for issue shall qualify for
disclosure as non-adjusting events, meaning the loans remain as current liabilities:

a. Refinancing on a long-term basis

b. Rectification of a breach of a long-term loan agreement
c. The granting by the lender of a grace period to rectify a breach of a long-term loan arrangement
ending at least 12 months after the long-term period.

Presentation of current liabilities

Under PAS 1, as a minimum, the face of the statement of financial position shall include the following line items
for current liabilities:

1. Trade and other payables

2. Current provisions
3. Short-term borrowing
4. Current portion of long-term debt
5. Current tax liability

Estimated Liabilities

Estimated liabilities are obligations which exist at the end of reporting period although their amount is not
definite. The date when the obligation is due is not also definite and the exact payee cannot be identified or
determined.

Estimated liabilities are either current or noncurrent in nature. Under PAS 37, an estimated liability is
considered as “provision” which is both probable and measurable.

e.g. liability for premium, award points, warranties, gift certificates and bonus.

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Reference: Valix, C. T., Peralta, Jose F., Valix, C A M. (2014). Financial Accounting Volume 2