AE 16: INTERMEDIATE ACCOUNTING 2 A.

L Pericon

Module 1: Liabilities
Definition of Liabilities

(1) Present Obligation (2) Obligation is to transfer (3) Arises from a past event
an economic resource or transaction

➔ Entity has no practical
ability to avoid.
➔ Entity liable must be
identified.
➔ Payee is not required to be
identified.
➔ Legal-binding contract or
statutory requirement e.g.
AP for goods and services,
taxes, loans with banks.
➔ Constructive-normal
business practice, custom,
and desire to maintain
good business relations or
act in an equitable manner.
➔ Pay cash, transfer the ➔ Not recognized until
non-cash asset or provide incurred
service at some future ➔ Past event is the obligating
time. event
➔ Compare and contrast ➔ The entity has not realistic
Cash and Share/Stock alternative but to settle the
Dividend obligation created by the
● Cash dividend event.
requires the
payment of CASH Examples of Obligating events:
which is an ● Acquisition of goods gives
economic resource rise to AP. An obligation
that will be paid to event is the acquisition of
stockholders as of goods.
record date. Hence, ● Receipt of a bank loan
A LIABILITY. results in an obligation to
● Share/Stock repay the loans.
dividend will require Obligating event is the
the issuance of receipt of cash from the
own shares of the bank as a consequence of
entity, hence, NOT a bank loan.
A LIABILITY.
● Share/Stock
dividend payable is
classified

Measurement of Liabilities in General:

Initial measurement - at present value
Subsequent measurement - at amortized cost.
Measurement of Current Liabilities:
Not discounted anymore
Measured, recorded, and reported at their face amount or face value.
The discount or difference between the face value and present value is usually not material because of
its short-term payment.
Payable within 12 months after the balance sheet date, hence, the present value is very minimal to be
amortized over 12 months.
Measurement of Non-Current Liabilities:
Initial measurement - at present value
Subsequent measurement - at amortized cost
Interest-bearing note
- Initial measurement - at face value
- Subsequent measurement - at face value
- Therefore the face value and present value is the same for interest-bearing note.
Non-Interest Bearing note
- Initial measurement - at present value
- Subsequent measurement - at amortized cost.
- Amortized cost is amortizing the discount over the term of payment of the note. E.g. bonds
payable.
AE 16: INTERMEDIATE ACCOUNTING 2 A.L Pericon

Classification of Liabilities as Current:

a. Expects the settlement 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.
e. When a normal operating cycle is not clearly identifiable, its duration is assumed to be 12 months.

EXCEPTION:

(1) Long-term debt falling due within one year or which is due to be settled within 12 months
after the reporting period is classified as CURRENT, even if:

● The origin term was for a period longer than 12 months.

● 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.

(2) Liabilities are classified as CURRENT even if settled more than 12 months after the reporting
period such as:

● Trade payables and accruals for employee and other operating costs are part of the working capital
used in the entity’s normal operating cycle.

Examples of Current Liabilities: (Financial Liabilities held for trading)

➔ Incurred with an intention to repurchase these in the near term
➔ The issuer of the quoted debt instrument may buy back in the near term depending on the changes
in fair value.
➔ Example: Short-term bonds callable within 3 months before its maturity date.

Classification of Liabilities as non-current:

All liabilities are not classified as current. Classifications:
➔ Non-current portion of a long-term debt
➔ Finance lease liability
➔ Deferred tax liability
➔ Long-term obligation of officers
➔ Long-term deferred revenue
When refinancing on a longer basis is completed ON or BEFORE the end of the reporting period.
- The refinancing is an adjusting event that will require classification to non-current.
When 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 even if it is due within a shorter period.
When the entity has an unconditional right under the existing facility to defer settlement of the liability
for at least 12 months after the reporting period.

NOTE: REFINANCING OR ROLLING OVER MUST BE THE DISCRETION OF THE ENTITY

(DEBTOR)
AE 16: INTERMEDIATE ACCOUNTING 2 A.L Pericon

WHAT ARE COVENANTS?

● Often attached to borrowing agreements which represent undertakings by the borrowing.

● Refer to restrictions on the borrower as to undertaking further borrowings, paying dividends,
maintaining a specified level of working capital, and so forth.

HOW DOES A BREACH OF COVENANTS AFFECT THE CLASSIFICATION OF A LIABILITY?

● When certain conditions relating to the borrower’s financial situation are breached, the liability
becomes PAYABLE ON DEMAND.
● Breach of covenant makes a non-current liability to a CURRENT LIABILITY even if the lender has
agreed AFTER THE REPORTING PERIOD and BEFORE THE STATEMENTS ARE AUTHORIZED
FOR ISSUE, not to demand payment as a consequence of the breach.
● Liability is classified as current because, at the end of the reporting period, the entity DOES NOT
HAVE AN UNCONDITIONAL RIGHT TO DEFER SETTLEMENT for at least 12 months after that
date.

EXCEPTION:

➔ Classified as non-current if the lender has agreed on or before the end of the reporting period to
provide a grace period ending at least 12 months after that date.

GRACE PERIOD:

● Period within which the entity can rectify the breach and during which the lender cannot demand
immediate repayment.

PRESENTATION OF CURRENT LIABILITIES:

Minimum line items of current liabilities of the statement of financial position.

(a) Trade and other payables

- Accounts payable, notes payable, accrued interest on NP, dividends payable, and accrued
expenses.
(b) Current provisions
(c) Short-term borrowings
(d) Current portion of long-term debt
(e) Current tax liability
Estimated Liabilities:
Obligations that exist at the end of the reporting period although the amount due, due date, and exact
payee cannot be definitely determinable or identifiable
May either be current or non-current in nature
Examples: Estimated liability for the premium, award points (miles), gift certificates and bonus.
Deferred or Unearned revenues classified as liabilities:
Income already received by not yet earned.
Maybe realizable within one year or in more than 1 year after the end of the reporting period.
Classification of deferred or unearned revenues

Classified as Current liability if realizable WITHIN 1 YEAR

● Examples: unearned interest income, unearned rental income, unearned airline ticket sales, and
unearned subscriptions revenues

Classified as Non-Current liability if realizable MORE THAN 1 YEAR

● Example: unearned revenues from long-term service contracts, long-term leasehold advances.
AE 16: INTERMEDIATE ACCOUNTING 2 A.L Pericon

ILLUSTRATION 1 - SERVICE CONTRACTS

➔ An entity sells equipment service contracts agreeing to service equipment for a 2-year period.

➔ Concepts application:

- Cash receipts from contracts are credited to unearned service revenue.

- Service contract costs are charged to service contract expense\
- Revenue from the service contracts is recognized as earned over the service period of the contracts.

➔ The following transactions occur in the first year:

- Cash receipts from service contracts sold = 1,000,000

- Service contracts costs paid = 500,000
- Service contract revenue recognized = 800,000

JOURNAL ENTRIES FOR THE FIRST YEAR:

(1) To record the cash receipts from service contracts sold:

Cash 1,000,000

Unearned Service Revenue 1,000,000

(2) To record the service contract costs paid:

Service Contract Expense 500,000

Cash 500,000

(3) To record the service contract revenue recognized:

Unearned Service Revenue 800,000

Service Contract Expense 800,000

ILLUSTRATION 2 - GIFT CERTIFICATE PAYABLE

➔ Gift certificates are usually issued by department stores, malls, and redeemable in merchandise.

(1) When the gift certificate is sold:

Cash xxx

Gift Certificates Payable xxx

The latter account is a current liability

AE 16: INTERMEDIATE ACCOUNTING 2 A.L Pericon

(2) When the gift certificates are redeemed:

Gift Certificates Payable xxx

Sales xxx

(3) When the gift certificates expire or when gift certificates are not redeemed:

Gift Certificates Payable xxx

Forfeited Gift Certificates xxx

The Philippine DTI ruled that gift certificates no

longer have an expiration period.

ILLUSTRATION 3 - BONUS COMPUTATION

➔ Bonus is compensation to key officers and employees for superior income realized during the year.

➔ Purpose is to motivate officers and employees by directly relating their well-being to success of the
entity.

➔ Compensation plan results in liability must be measured and reported in the financial statements.

(1) Percent income BEFORE BONUS AND BEFORE TAX

Income before bonus and tax 4,400,000

Bonus 10%

Income tax rate 30%

Computation:

Income before bonus tax 4,400,000

Multiply by 10%
Bonus 440,000

(2) Percent of income AFTER BONUS BUT BEFORE TAX

Income before bonus and tax 4,400,000

Bonus 10%

Income tax rate 30%

AE 16: INTERMEDIATE ACCOUNTING 2 A.L Pericon

Computation: where B = Bonus

(1) B = .10 (4,400,000 - B)

(2) B + 10B = 440,000

(3) B = 440,000 - .10B

(4) 1.10B = 440,000

(5) B = 440,000 / 1.1

(6) B = 400,000
AE 16: INTERMEDIATE ACCOUNTING 2 A.L Pericon