CHAPTER 1 – LIABILITIES

LIABILITIES The past event that leads to a legal or constructive

The Revised Conceptual Framework for Financial
Reporting provides the following definition of liabilities:
Liabilities are present obligations of an entity to transfer
an economic resource as a result of past events.
Accordingly, the essential characteristics of an
accounting liability are:
a. The entity has a present obligation.
An obligation is a duty or responsibility that an entity
has no practical ability to avoid.
The entity liable must be identified but it is not
necessary that the payee to whom the obligation is
owed be identified.
b. The obligation is to transfer an economic resource.
This is the very heart of the definition of an
accounting liability.
The economic resource is the asset that represents
a right with a potential to produce economic benefits.
Specifically, the obligation must be to pay cash,
transfer noncash asset or provide service at some
future time.
c. The liability arises from a past event.
This means that the liability is not recognized until it
is incurred.
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.
This is normally the case, for example, with accounts
payable for goods and services received.
Constructive obligations also give rise to liabilities by
reason of normal business practice, custom and a desire
to maintain good business relations or act in an equitable
manner.
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.
For example, the acquisition of goods gives rise to
accounts payable. The obligating event is the acquisition
of goods.
The receipt of a bank loan results in an obligation to
repay the loan.
The obligating event is the cash received from the bank
as a consequence of the bank loan.
Examples of liabilities
The more common types of liabilities include the
following:
a. Accounts payable to suppliers for the purchase of
goods
b. Amounts withheld from employees for taxes and for
contributions to the Social Security System
c. Accruals for salaries, interest, rent, taxes, product
warranties and profit sharing bonus
d. Cash dividends declared but not paid
e. Deposits and advances from customers
f. Debt obligations for borrowed funds – notes,
mortgages and bonds payable
g. Income tax payable
h. Unearned revenue
Measurement of current liabilities
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 but measured, recorded
and reported at their face amount.
The reason is that the discount or the difference between
the face amount and the present value is usually not
material and therefore ignored.

Measurement of noncurrent liabilities

Transfer of an economic resource
Noncurrent liabilities, for example, bonds payable and
Without payment of money, without transfer of noncash
noninterest-bearing note payable, are initially measured
asset, without performance of service, there is no
at present value and subsequently measured at
accounting liability.
amortized cost.
A crystallization of the definitive concept of an
If the long-term note payable is interest-bearing, it is
accounting liability is when an entity declares cash
initially and subsequently measured at face amount.
dividend.
In this case, the face amount is equal to the present
In such a case, there is an obligation to pay cash, hence,
value of the note payable.
accounting liability exists.
The “amortized cost measurement” is taken up in a later
But when an entity declares share dividend, there is no
chapter in related to bonds payable.
accounting liability.
The obligation is to issue the entity's own shares.
Current liabilities
The issuance of the entity's own shares is not a transfer
PAS 1, paragraph 69, provides that an entity shall
of noncash asset because the share capital is an equity
classify liability a as current when:
item.
a. The entity expects to settle the liability within the
Thus, share dividend payable is classified as part of
entity’s operating cycle.
equity rather than an accounting liability.
b. The entity holds the liability primarily for the purpose
of trading.
c. The liability is due to be settled within twelve
Past event
months after the reporting period.
Another essential characteristic of a liability is that the
d. The entity does not have an unconditional right to
liability must arise from a past transaction or event.
defer settlement of liability for at least twelve months
after the reporting period.
CHAPTER 1 – LIABILITIES

These covenants are actually restrictions on the

Trade payables and accruals for employee and other
borrower as to undertaking further borrowings, paying
operating costs are part of the working capital used in
dividends, maintaining specified level of working capital
the entity's normal operating cycle.
and so forth.
Such operating items are classified as current liabilities
even if settled more than twelve months after the
reporting period. Breach of covenants
Under these covenants, if certain conditions relating to
When the entity's normal operating cycle is not clearly
the borrower’s financial situation are breached, the
identifiable, its duration is assumed to be twelve months.
liability becomes payable on demand.
Other current liabilities are not settled as part of the
PAS 1, paragraph 74, provides that such a liability is
normal operating cycle but are due for settlement within
classified as current even if the lender has agreed, after
twelve months after the reporting period or held primarily
the reporting period and before the statements are
for the purpose of trading.
authorized for issue, not to demand payment as a
Examples of such current liabilities are financial liabilities consequence of the breach.
held for trading, bank overdraft, dividends payable,
This liability is classified as current because at the end
income taxes, other nontrade payables and current
of the reporting period, the entity does not have an
portion of noncurrent financial liabilities.
unconditional right to defer settlement for at least twelve
Financial liabilities held for trading are financial liabilities months after that date.
that are incurred with an intention to repurchase them in
However, the liability is classified as noncurrent if the
the near term.
lender has agreed on or before the end of the
An example is a quoted debt instrument that the issuer reporting period to provide a grace period ending at
may buy back in the near term depending on changes in least twelve months after that date.
fair value.
In this context, a grace period is a period within which
the entity can rectify the breach and during which the
lender cannot demand immediate repayment.
Noncurrent liabilities
The term noncurrent liabilities is a residual definition.
All liabilities not classified as current are classified as Presentation of current liabilities
noncurrent liabilities. Noncurrent liabilities include: Under Paragraph 54 of PAS 1, as a minimum, the face
a. Noncurrent portion of long-term debt of the statement of financial position shall include the
b. Finance lease liability following line items for current liabilities:
c. Deferred tax liability
a. Trade and other payables line item
d. Long-term obligation to officers
b. Current provisions
e. Long-term deferred revenue
c. Short-term borrowing
d. Current portion of long-term debt
e. Current tax liability
Long-term debt falling due within one year
A liability which is due to be settled within twelve months The term trade and other payables is a line item for
after the reporting period is classified as current, even if: accounts payable, notes payable, accrued interest on
note payable, dividends payable and accrued expenses.
a. The original term was for a period longer than twelve
months. No objection can be raised if the trade accounts and
b. An agreement to refinance or to reschedule payment notes payable are separately presented.
on a long-term basis is completed after the reporting
period and before the financial statements are
authorized for issue. Estimated liabilities
Estimated liabilities are obligations which exist at the end
However, if the refinancing on a long-term basis is
of reporting period although their amount is not definite.
completed on or before the end of the reporting
period, the refinancing is an adjusting event and In many cases, the date when the obligation is due is not
therefore the obligation is classified as noncurrent. also definite and in some instances, the exact payee
cannot be identified or determined.
Moreover, if the entity has the discretion to refinance or
roll over an obligation for at least twelve months after the But inspite of these circumstances, the existence of the
reporting period under an existing loan facility, the estimated liabilities is valid and unquestioned.
obligation is classified as noncurrent even if it would
Estimated liabilities are either current or noncurrent in
otherwise be due within a shorter period.
nature.
If the entity has an unconditional right under the
Examples include estimated liability for premium, award
existing loan facility to defer settlement of the liability for
points, warranties, gift certificates and bonus.
at least twelve months after the reporting period, the
obligation is considered part of the entity's long-term
refinancing.
Deferred revenue
Note that the refinancing or rolling over must be at the Deferred revenue or unearned revenue is income
discretion of the entity. already received but not yet earned.
Deferred revenue may be realizable within one year or in
more than one year after the end of the reporting period.
Covenants
If the deferred revenue is realizable within one year, it is
Covenants are often attached to borrowing agreements
a current liability.
which represent undertakings by the borrower.
CHAPTER 1 – LIABILITIES

Typical examples of current deferred revenue are This compensation plan results in liability that must be
unearned interest income, unearned rental income and measured and reported in the financial statements. The
unearned subscription revenue. bonus computation usually has four variations:
If the deferred revenue is realizable in more than one 1. Bonus is expressed as a certain percent of income
year, it is classified as noncurrent liability. before bonus and before tax.
2. Bonus is expressed as a certain percent of income
Typical examples of noncurrent deferred revenue are
after bonus but before tax.
unearned revenue from long-term service contracts and
3. Bonus is expressed as a certain percent of income
long-term leasehold advances.
after bonus and after tax.
4. Bonus is expressed as a certain percent of income
after tax but before bonus.
Illustration
An entity sells equipment service contracts agreeing to
service equipment for a 2-year period.
Illustration
Cash receipts from contracts are credited to unearned Income before bonus and before tax 4,400,000
service revenue and service contract costs are charged Bonus 10%
to service contract expense. Income tax rate 30%
Revenue from service contracts is recognized as earned
over the service period of the contracts.
Case 1 – Before bonus and before tax
The following transactions occur in the first year: Income before bonus and before tax 4,400,000
Multiply by 10%
Cash receipts from service contracts sold 1,000,000
Bonus 440,000
Service contracts costs paid 500,000
Service contract revenue recognized 800,000
Case 2 – After bonus but before tax
B = .10 (4,400,000 – B)
Journal entries for first year B = 440,000 – .10B
1. To record the cash receipts from service contracts B + .10B = 440,000
sold: 1.10B = 440,000
B = 440,000/1.10
Cash 1,000,000 B = 400,000
Unearned service revenue 1,000,000
Proof
2. To record the service contract costs paid: Income before bonus and before tax 4,400,000
Service contract expense 500,000 Less: Bonus 400,000
Cash 500,000 Income after bonus but before tax 4,000,000
Multiply by 10%
3. To record the service contract revenue recognized:
Bonus 400,000
Unearned service revenue 800,000
Service contract revenue 800,000 Case 3 – After bonus and after tax
B = .10 (4.4M – B – T)
T = .30 (4.4M – B)
Gift certificates payable B = .10 [4.4M – B – .30 (4.4M – B)]
Many megamalls, department stores and supermarkets B = .10 (4.4M – B – 1.32M + .30B)
sell gift certificates which are redeemable in B = 440,000 – .10B – 132,000 + .03B
merchandise. The accounting procedures are: B + .10B – .03B = 440,000 – 132,000
1. When the gift certificates are sold: 1.07B = 308,000
Cash xx B = 308,000 / 1.07
Gift certificates payable xx B = 287,850
T = .30 (4,400,000 – 287,850)
2. When the gift certificates are redeemed: T = 1,233,645
Gift certificates payable xx Proof
Sales xx Income before bonus and before tax 4,400,000
3. When the gift certificates expire or when gift Less Bonus 287,850
certificates are not redeemed: Less: Tax 1,233,645
Income after bonus and after tax 2,878,505
Gift certificates payable xx Multiply by 10%
Forfeited gift certificates xx Bonus 287,850
The Philippine Department of Trade and Industry ruled
that gift certificates no longer have an expiration period. Case 4 – After tax but before bonus
B = .10 (4.4M – T)
T = .30 (4.4M – B)
Bonus computation B = .10 [4.4M – .30 (4.4M – B)]
Large entities often compensate key officers and B = .10 (4.4M – 1.32M + .30B)
employees by way of bonus for superior income realized B = 440,000 – 132,000 + .03B
during the year. B – .03B = 440,000 – 132,000
The main purpose of this scheme is to motivate officers .97B = 308,000
and employees by directly relating their well-being to the B = 308,000 / .97
success of the entity. B = 317,526
CHAPTER 1 – LIABILITIES

Proof
Income before bonus and before tax 4,400,000
Less: Tax (4,400,000 – 317,526 × 30%) 1,224,742
Income after tax but before bonus 3,175,258
Multiply by 10%
Bonus 317,526

Refundable deposits
Refundable deposits consist of cash or property received
from customers but which are refundable after
compliance with certain conditions.
The best example of a refundable deposit is the
customer deposit required for returnable containers like
bottles, drums, tanks and barrels.

Illustration
A deposit of P10,000 is required from the customer for
returnable containers. The containers cost P8,000.
Cash 10,000
Container’s deposit 10,000
The containers' deposit account is usually classified as
current liability.
If the customer returns the containers, the deposit is
simply refunded.
However, if the customer fails to return the containers,
the deposit is considered the sale price of the containers.
The excess of the deposit over the cost of the containers
is considered as gain.