Accounting for Liabilities

LIABILITIES

Definition

The framework for the preparation of financial statements and PAS/IAS 37 on

Provisions, Contingent Liabilities and Contingent Assets defined liabilities as
follow:

A liability is 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.

Present Obligation of the entity arising from past events. An essential

characteristic of a liability is that the entity has a present obligation. Obligations
may be legally enforceable as a consequence of a binding contract or statutory
requirement. This is normally the case, for example, with amounts payable for
goods and services received and those arising from taxes. Obligations may also
be constructive like those arising from normal business practice, custom and a
desire to maintain good business relations or act in an equitable manner. If, for
example, an entity decides as a matter of policy to rectify faults in its products
even when these become apparent after the warranty period has expired, the
amounts that are expected to be expended in respect of goods already sold are
liabilities.

A distinction needs to be drawn between a present obligation and a future

commitment. A decision by the management of an entity to acquire assets in the
future or purchase order generally does not, of itself, give rise to a present
obligation. An obligation normally arises only when the asset is delivered or the
entity enters into an irrevocable agreement to acquire the asset. In the latter
case, the irrevocable nature of the agreement means that the economic
consequences of failing to honor the obligation, for example, because of the
existence of a substantial penalty, leave the entity with little, if any, discretion to
avoid the outflow of resources to another party. The mere signing of an
employment contract with an employee does not give rise to a liability. The
liability for salaries shall be recognized when the employees render services to
the entity.

Liabilities result from past transactions or other past events. Thus, for example,
the acquisition of goods and the use of services give rise to trade payables
(unless paid for in advance or on delivery) and the receipt of a bank loan results
in an obligation to repay the loan. An entity may also recognize future rebates
based on annual purchases by customers as liabilities; in this case, the sale of
the goods in the past is the transaction that gives rise to the liability.
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It is necessary that obligation involves another party to whom the

obligation is owed. However, it is not necessary that the party to whom
the obligation is owed be identified.

An obligation always involves another party to whom the obligation is owed. It is

NOT necessary, however, to know the identity of the party to whom the obligation
is owed—indeed the obligation may be to the public at large. Examples of such
obligations are penalties or clean-up costs for unlawful environmental damage
and decommissioning costs of an oil installation or a nuclear power station

Because an obligation always involves a commitment to another party, it follows

that a management or board decision does not give rise to a constructive
obligation at the balance sheet date unless the decision has been communicated
before the balance sheet date to those affected by it in a sufficiently specific
manner to raise a valid expectation in them that the entity will discharge its
responsibilities like declaration of dividends.

Settlement of which is expected to result in an outflow from the entity of

resources embodying economic benefits. The settlement of a present obligation
usually involves the entity giving up 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:
a. payment of cash;
b. transfer of other assets;
c. provision of services;
d. replacement of that obligation with another obligation; or
e. conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a creditor

waiving or forfeiting its rights or condonation

Declaration of stock dividend does not give rise to a liability since this would not
result to a transfer or outflow of asset because stocks are equity items. Although
an existing liability may be settled by converting the liability to equity in cases of
equity swap under debt restructuring.

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Recognition

For a liability to qualify for recognition there must be not only a present obligation
but also the probability of an outflow of resources embodying economic benefits
to settle that obligation AND that the amount at which the settlement will take
place can be measured reliably .

The PROBABILITY of future economic benefits refers to the degree of

uncertainty that the future economic benefits associated with the item will flow
from the enterprise. An outflow of resources or other event is regarded as
probable if the event is more likely than not to occur, for example the probability
that the event will occur is greater than the probability that it will not (greater than
50%). Where it is not probable that a present obligation exists, an entity
discloses a contingent liability, unless the possibility of an outflow of resources
embodying economic benefits is remote

The use of estimates is an essential part of the preparation of financial

statements and does not undermine their RELIABILITY. This is especially true in
the case of provisions, which by their nature are more uncertain than most other
balance sheet items. Except in extremely rare cases, an entity will be able to
determine a range of possible outcomes and can therefore make an estimate of
the obligation that is sufficiently reliable to use in recognizing a provision. The
definition of a liability follows a broader approach that when it involves a present
obligation and satisfies the rest of the definition, it is a liability even if the amount
has to be estimated. Examples include provisions for payments to be made
under existing warranties and provisions to cover pension obligations.

Under PAS/IAS 37, liabilities are divided into the following:

a. Trade and other payables
b. Provisions
c. Contingent liabilities

Thus liabilities are accounted based on the table below:

Outflow of Determination of
Liability resources amount FS presentation
Recognize at
Trade and other Reliably
Probable Face of Balance
payables measurable
Sheet
Reliably Recognize at
Provisions Probable measurable with Face of Balance
estimation Sheet

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Contingent Probable Not reliably Disclosures in the

liabilities measurable notes to FS
Reasonably Reliably
Disclosures in the
possible measurable
notes to FS
(not probable) or not
Reliably Ignore (neither
None
Remote measurable recognize or
or not disclose)

Accruals are often reported as part of trade and other payables, whereas
provisions are reported separately.

Classification

Two (2) ways to classifying or presenting liabilities in the balance sheet:

1. Current and Noncurrent or
2. Order of Liquidity

PAS/IAS 1 requires that an entity shall present current and noncurrent liabilities,
as separate classifications on the face of its balance sheet except when a
presentation based on liquidity provides information that is reliable and is more
relevant. When that exception applies, all liabilities shall be presented broadly in
order of liquidity.

Whichever method of presentation is adopted, for each liability line item that
combines amounts expected to be settled (a) no more than twelve months after
the balance sheet date and (b) more than twelve months after the balance sheet
date, an entity shall disclose the amount expected to be recovered or settled
after more than twelve months.

A liability shall be classified as current when it satisfies any of the following

criteria:
(a) it is expected to be settled in the entity’s normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is due to be settled within twelve months after the balance sheet
date; or
(d) the entity does not have an unconditional right to defer settlement
of the liability for at least twelve months after the balance sheet
date.

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All other liabilities shall be classified as non-current.

Some current liabilities, such as trade payables and some accruals for employee
and other operating costs, are part of the working capital used in the entity’s
normal operating cycle. Such operating items are classified as current liabilities
even if they are due to be settled more than twelve months after the balance
sheet date. When the entity’s normal operating cycle is not clearly identifiable, its
duration is assumed to be twelve months.

Other current liabilities are not settled as part of the normal operating cycle, but
are due for settlement within twelve months after the balance sheet date
(examples are bank overdrafts, and the current portion of non-current financial
liabilities, dividends payable, income taxes and other nontrade payables) or held
primarily for the purpose of being traded (financial liabilities classified as held for
trading in accordance with PAS/IAS 39).

Financial liabilities that provide financing on a long-term basis (ie are not part of
the working capital used in the entity’s normal operating cycle) and are not due
for settlement within twelve months after the balance sheet date are non-current
liabilities.

An entity classifies its financial liabilities as current when they are due to be
settled within twelve months after the balance sheet date, even if:
(a) the original term was for a period longer than twelve months; and
(b) an agreement to refinance, or to reschedule payments, on a long-
term basis is completed AFTER the balance sheet date and before
the financial statements are authorised for issue.

If an entity expects, and has the discretion, to refinance or roll over an obligation
for at least twelve months after the balance sheet date under an existing loan
facility, it classifies the obligation as non-current, even if it would otherwise be
due within a shorter period. However, when refinancing or rolling over the
obligation is not at the discretion of the entity (for example, there is no agreement
to refinance), the potential to refinance is not considered and the obligation is
classified as current.

In a borrowing agreement or covenant, when an entity breaches an undertaking

under a long-term loan agreement on or before the balance sheet date with the
effect that the liability becomes payable on demand, the liability is classified as
current, even if the lender has agreed, after the balance sheet date and before
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the authorization of the financial statements for issue, not to demand payment as
a consequence of the breach. The liability is classified as current because, at the
balance sheet date, the entity does not have an unconditional right to defer its
settlement for at least twelve months after that date.

However, the liability is classified as non-current if the lender agreed by the

balance sheet date to provide a grace period ending at least twelve months after
the balance sheet date, within which the entity can rectify the breach and during
which the lender cannot demand immediate repayment.

In respect of loans classified as current liabilities, if the following events occur

between the balance sheet date and the date the financial statements are
authorized for issue, those events qualify for disclosure as non-adjusting events
in accordance with PAS/IAS 10 Events after the Balance Sheet Date:
(a) refinancing on a long-term basis;
(b) rectification of a breach of a long-term loan agreement; and
(c) the receipt from the lender of a period of grace to rectify a breach of
a long-term loan agreement ending at least twelve months after the
balance sheet date.

Measurement

Liabilities are measured at amounts established at exchanges which would

represent the amount to be paid or discounted amount. Some liabilities can be
measured only by using a substantial degree of estimation that would result to
the recognition of provision.

Under PAS/IAS 37 certain standards need to be followed in the application and

measurement of provisions as follows:

Best Estimate

The amount recognized as a provision shall be the best estimate of the

expenditure required to settle the present obligation at the balance sheet
date.

The risks and uncertainties that inevitably surround many events and
circumstances shall be taken into account in reaching the best estimate of a
provision.

Future events that may affect the amount required to settle an obligation shall
be reflected in the amount of a provision where there is sufficient objective
evidence that they will occur.

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Present Value
Where the effect of the time value of money is material, the amount of a
provision shall be the present value of the expenditures expected to be
required to settle the obligation. The discount rate (or rates) shall be a pre-tax
rate (or rates) that reflect(s) current market assessments of the time value of
money and the risks specific to the liability. The discount rate(s) shall not
reflect risks for which future cash flow estimates have been adjusted.

Expected Disposal of Assets

Gains from the expected disposal of assets shall not be taken into account in
measuring a provision.

Future Operating Losses

Provisions shall not be recognized for future operating losses.

Reimbursements

Where some or all of the expenditure required to settle a provision is

expected to be reimbursed by another party, the reimbursement shall be
recognized when, and only when, it is virtually certain that reimbursement will
be received if the entity settles the obligation. The reimbursement shall be
treated as a separate asset. The amount recognized for the reimbursement
shall not exceed the amount of the provision.

In the income statement, the expense relating to a provision may be

presented net of the amount recognized for a reimbursement.

Changes in Provisions

Provisions shall be reviewed at each balance sheet date and adjusted to

reflect the current best estimate. If it is no longer probable that an outflow of
resources embodying economic benefits will be required to settle the
obligation, the provision shall be reversed.

Use of Provisions

A provision shall be used only for expenditures for which the provision was
originally recognized.

Onerous Contracts

If an entity has a contract that is onerous, the present obligation under the

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contract shall be recognized and measured as a provision An onerous

contract as a contract in which the unavoidable costs of meeting the
obligations under the contract exceed the economic benefits expected to be
received under it. The unavoidable costs under a contract reflect the least net
cost of exiting from the contract, which is the lower of the cost of fulfilling it
and any compensation or penalties arising from failure to fulfil it.

Restructuring
A constructive obligation to restructure arises only when an entity:
(a) has a detailed formal plan for the restructuring identifying at least:
(i) the business or part of a business concerned;
(ii) the principal locations affected;
(iii) the location, function, and approximate number of
employees who will be compensated for terminating their
services;
(iv) the expenditures that will be undertaken; and
(v) when the plan will be implemented; and
(b) has raised a valid expectation in those affected that it will carry out
the restructuring by starting to implement that plan or announcing
its main features to those affected by it.
A restructuring provision shall include only the direct expenditures arising
from the restructuring, which are those that are both:
(a) necessarily entailed by the restructuring; and
(b) not associated with the ongoing activities of the entity.

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