Accounting for Liabilities
Characteristics of an
Definition
• “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.”
accounting liability are:
• The liability is the present
obligation of a particular
entity
• The liability arises from
past transaction or event
• The settlement of the
liability requires an outflow
of resources embodying
economic benefits
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Measurement of liabilities
 PAS 39 provides that an entity shall recognize financial liability
1. Initially at fair value plus transaction costs that are directly attributable to the issue of
financial liability.
2. After initial recognition, an entity shall measure a financial liability at amortized cost.
3. 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.
 All liabilities are measured at present value or discounted amount.
1. Current liabilities – are measured, recorded and reported at their face amount.
2. Non current liabilities – are measured at face amount or present value depending on whether
they are interest-bearing or non-interest bearing.
a. Interest bearing – is measured at face amount because in this case, the face amount is
already the present value of the obligation
b. Non-interest bearing – is measured at present value. This requires amortization of the
discount or the difference between the face amount and the present value using the
effective method.

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Classification of liabilities
• The entity expects to settle the liability within the entity’s
operating cycle.
Current liabilities – PAS • The entity holds the liability primarily for the purpose of
1 paragraph 69 provides trading
that an entity shall • The liability is due to be settled within twelve months after
classify a liability as the reporting period
current when: • The entity does not have an unconditional right to defer
settlement of the liabilities for at least 12 months after the
reporting period.

Non-current liabilities –
is a residual definition. • Long-term debts
All liabilities not • Finance lease liability
classified as current are • Deferred tax liability
classified as non- • Long-term obligation to entity officers
current liabilities. • Long-term deferred revenues
Examples are:

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 COVENANTS
Covenants
Are provision attached to the borrowings, (long–term loans) normally it is a
restriction imposed on the borrower such as non declaration of dividends,
no further borrowings, maintaining specified level of working capital and so
forth.

If this provision are breach, the loan payable become payable on demand,
hence the long-term loan will become current liability.
However, if the lender has agreed by the end of the reporting period to
provide a grace period (a grace period is a period within which the entity can
rectify the breach ), such loan payable will remain a long-term loan, hence
the lender can not demand immediate repayment

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

1. Refinancing on a long-term basis

2. Rectification of a breach of a long-term agreement
3. 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 reporting period.

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 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 & other payables

2. Current provisions
3. Short-term borrowings
4. Current portion of long-term debt

5. Current tax liability

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 ESTIMATED LIABILITIES
Estimated liabilities are obligations which exist and valid at the end of the
reporting period although their

• Amount is not definite

• The date when the obligation is due is not also definite
• The exact payee cannot be identified or determined
But inspite of these circumstances, the existence of the estimated liabilities is
valid and unquestioned.

Examples of estimated liabilities

• Premiums
• Warranty or guarantee
• Gift certificate
• Refundable deposits
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 Estimated liabilities - Premium
Premiums are articles of value such as toys, dishes, silverware, & other goods and
cash payment given to customers as a result of past sales or sales promotion
activities. These premiums are offer to customers (in return for product labels,
box tops, wrappers and coupons) to stimulate the sale of the product.

The accounting procedures for the acquisition of premium and recognition of the
premium liability are as follows:
When the premiums are purchase
Premium xx
Cash xx
When the premiums are distributed to customer
Premium expenses xx
Premiums xx
At the end of the year, if premium are still outstanding
xx
Premium expenses
xx
Estimated premium liability

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Estimated liabilities - Warranty or Guarantee
Warranty or guarantee provides free repair service or replacement during
a specified period if the products are defective. A company may incur
significant cost if the products sold prove to be defective in the future
within the specified period of time of warranty or guarantee.
Accordingly, a liability is incurred, at the point of sale.

There are 2 approach followed in accounting for the warranty cost:

1. Accrual approach – this approach has the soundest theoretical support
because it properly matches cost with revenue.
2. Expenses as incurred approach – this approach of expensing warranty cost
only when actually incurred.

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 Est. liabilities - Warranty or Guarantee (Continuation)
Accounting procedures for the recognition of warranty or guarantee cost:

Accrual Approach Expense Approach

1. To take up estimated warranty cost
Warranty expense xx xx
Estimated warranty expense / Cash xx xx
2. To take up payment of actual warranty cost
Estimated warranty expenses xx
Cash xx
3. To take up a change in estimate

a. If the actual cost exceed the estimate

Warranty expense xx
Estimated warranty expense xx
b. If the actual cost is less than the estimate
Estimated warranty expense xx
Warranty expense xx

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 Estimated liabilities – Gift Certificate
Many mega malls, department stores and supermarkets sell gift certificate, which
are redeemable in merchandise. The accounting procedures for gift certificate
are as follows:
Dr Cr
1. To take up sales of gift certificate
Cash xx
Gift certificate payable xx
2. To take up redeemed of gift certificate
Gift certificate payable xx
Sales xx
3 To take up expiration of gift certificate

Gift certificate payable xx

Forfeited gift certificate xx

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 Estimated liabilities – refundable deposit
Refundable deposits consists of cash or property received from
customers but which are refundable after compliance with certain
condition: The accounting procedures for refundable deposits are as
follows:
Dr Cr
1. To take up containers’ deposit
Cash xx
Containers’ deposit xx
2.
To take up customers returns for the container
Container’s deposit xx
Cash xx
3.
To take up customers failure to return the containers
Containers’ deposit xx
Containers xx
Gain on sales on containers xx

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 Accrued expenses & Deferred income
 Accrued expenses are expenses already incurred but not yet paid
 Formula:

Accrued expenses beg xx

Add: Expenses this year xx
Total xx
Less: Paid expenses xx
Accrued expenses, ending xx

 Deferred income are income already received but not yet earned
 Formula:

Deferred income, beginning xx

Add: Income received xx
Total xx
Less: Income earned xx
Deferred income, ending xx

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 PROVISION
A provision is an existing liability of uncertain
timing or uncertain amount. The essence of a
provision is that there is uncertainty about • The amount
the timing or amount of the future • The due date
expenditures. The liability definitely exists at
the end of the reporting period but the following • The payee
is indefinite:

Recognition of provision. PAS 37
states that a “provision shall be
recognized as a liability in the
financial statements under the
following conditions”:
• The entity has a present obligation, legal or constructive, as a result
of a past event
• It is probable that an outflow of resources embodying economic
benefits would be required to settle the obligation
• The amount of the obligation can be measured reliably

• No liability no disclosure is needed – if the provision is not probable

and not reliably measured
Treatment of provision • Disclosure is necessary – if the provision is probable but not reliably
measured
• Estimated liability – if the provision is probable and reliably measured

Distinction between provision & other liabilities:

Paragraph 11 of PAS 37 states that a provision there is a uncertainty about the timing or
amount of the future expenditures require for settlement, while in other liabilities such
as trade payable & accruals, there is a certainty about the timing or amount.

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 Provision continuation – Definition of terms:
Present obligation may be legal or constructive:
1. A Legal obligation is an obligation arising from a contract, either legislation or
operation of law.
2. A constructive obligation is an obligation that is derived from an entity’s action
where:
a. The entity has indicated to other parties that it will accept certain
responsibilities by reason of an established pattern of past practice,
published policy, or sufficient specific current statement.

b. The entity will discharge those responsibilities; hence it has created a valid
expectation on the part of the other parties.

Obligation event – is a past event that leads to a present obligation, that creates a
legal or constructive obligation because the entity has no realistic alternative but
to settle the obligation. This is the case where:

 the settlement can be enforced by law

 there’s a valid expectation that the entity will discharge the obligation

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 Recognition of Provision
To quality for recognition, a provision must be:

a. A present obligation and

b. A probable outflow of resources embodying economic benefits to
settle the obligation

An outflow of resources is regarded as “Probable” if the event is more

likely to occur than not to occur, meaning, the probability that the event
will occur is greater than the probability that it will not occur. As a rule
of thumb, “probable” means more than 50%.
Paragraph 25 of PAS 37 provides that the use of estimates is an essential part of
the preparation of financial statements and it does not undermine their
reliability. This is true in the case of provision, because provision is more
uncertain than most item in the statement of financial position. The standard
further, suggests that by using a range of possible outcomes, an entity usually
would be able to make an estimate of the obligation that is sufficient reliable.
When no reliable estimate can be made, no liability is recognized.

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 MEASUREMENT OF PROVISION
The amount recognized as a provision should be the best estimate of the
expenditure required to settle the present obligation at the end of the reporting
period. The “best estimate” is the amount that an entity would rationally pay to
settle the obligation at the end of reporting period. The estimates of outcome are
determined by:
1. The judgment of management supplemented by experience of similar transaction
and reports from independent experts.
2. When there is a continuous range of possible outcomes and each point in that range
is as likely as any other, the midpoint of the range is used.
3. When the provision being measured involves a large population of items, the
obligation is estimated by “weighing all possible outcomes by their associated
possibilities. This is statistical method of estimation is called “expected values”.

Other considerations:
1. Risk & uncertainties 4. Expected disposal of events 7. Use of provision

2. Present value of obligation 5. Reimbursements 8. Future operating losses

3. Future evens 6. Changes in provisions 9. Onerous contract

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 Restructuring
Definition: PAS 37 defines restructuring as a “program that is planned
and controlled by management and materially changes either the scope
of a business of an entity or the manner in which that business is
conducted.

Events that may qualify as restructuring includes the following:

1. Sale or termination of a line business
2. Closure of business location in a region or relocation of a business
activities from one location to another

3. Changes in management structure such as elimination of a layer of

management

4 Fundamental reorganization of an entity that has a material and

. significant impact on its operation

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 Recognition of the provision for restructuring
Recognition of the provision for restructuring is required because
a constructive obligation may arise from the decision to
restructure. Such will arise when these two (2) conditions are
present:
1. The entity has a detailed formal plan for the restructuring
outlining at least the business or part of the business being
restructured, the principal location affected, the functions, and
approximate number of employees who will be compensated for
terminating their employment, when the plan will be
implemented and the expenditures that will be undertaken.

2. The entity has raised valid expectation in the minds of those affected
that the entity will carry out the restructuring by starting to implement
the plan and announcing its main features to those affected by it.

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 Amount of restructuring provision
A restructuring provision shall include only the amount of direct
expenditures arising from the restructuring such as salaries, &
benefits of employees to be incurred after the operation cease and
expenditures that are associated with the closure of the operation.
PAS 37 excludes the following expenditures from the restructuring
provisions:

1. Cost of retraining or relocation continuing staff

2. Marketing or advertising program to promote the new company

image

3. Investment in new system and distribution network.

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CONTINGENT LIABILITY
Definition:
• The required disclosures are:
• A contingent liability is a present
obligation of which is either
probable or measurable but not
both. If the present obligation is
probable and the amount can be
measured reliably, the obligation
is not a contingent liability but
shall be recognized as provision.
Treatment of contingent liability
shall not be recognized in the
financial statements but shall be
disclosed only.
• Brief description of the nature
of the contingent liability.
• An estimate of its financial
effects
• An indication of the
uncertainties
• Possibility of reimbursement
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 BONDS PAYABLE

A bond is a formal unconditional promise, made under

seal, to pay a specified sum of money at a determinable
future date, and to make periodic interest payments at
a stated rate until the principal sum is paid.

A bond is a contract of debt whereby one party called

the issuer borrows funds from another party called the
investor. It is evidence by a certificate and the
contractual between the issuer and investor is
contained in another document known as bond
indenture.
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 Bonds indenture contains the following items:
1. Characteristics of the bonds 6. Access to corporate books &
records of trustee
2. Maturity date & provisions for 7. Certificate of bonds by trustee
payment
3. Establishment of a sinking 8. Provisions affecting mortgage
fund & the periodic deposit property, such as tax, insurance
therein coverage, collection of interest or
dividends on collateral
4. Grace period allowed to issuing 9. Required debt to equity ratio
company

5. Deposit to cover interest 10. Minimum working capital to be

payments maintained, if any

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 Types of bonds
Term bonds – are bonds with a single date of maturity. Term bonds may
require the issuing entity to establish a sinking fund to provide adequate
money to retire the bond issue at one time.
Serial bonds – are bonds with a series of maturity dates instead of
a single one. This means it allow the issuing entity to retire the
bonds by installments.

Mortgage bonds – are bonds secured by a mortgage on real properties.

Collateral trust bonds – are bonds secured by stocks and bonds of another
corporation.

Debenture bonds – are bonds without collateral security. These bonds are
unsecured and therefore rank as general creditors in the preference of credits

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Types of bonds (continuation)

Convertible bonds – are bonds that can be exchanged for shares of

the issuing entity.

Callable bonds – are bonds which may be called in for redemption

prior to the maturity date

Guaranteed bonds – are bonds issued whereby another party

promises to make payment if the borrowing entity fails to do so.

Junk bonds – are high-risk, high-yield bonds issued by enterprises

that are heavily indebted or otherwise in weak financial condition.

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 Accounting for issuance of bonds
There are two (2) approaches in accounting for the authorization and issuance of
bonds, namely:
1. Journal entry approach – a journal entry is made to record the authorized
bonds payable.

2. Memorandum approach – no entry is made upon the authorization of the entity to

issue bonds. Authorized bonds payable account is not maintained.

Journal entry approach Memorandum approach

Debit Credit Debit Credit

1. To take up the authorization of the issuance of the bonds

Unissued Bond payable xx NO ENTRY

Authorized bond payable xx

2. To take sales of bonds at face value

Cash xx xx

Unissued bond payable / Bond payable xx xx

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 Issuance of bonds
The nominal rate of interest is the rate appearing on the face of the bond certificate. It is that interest which the issuing entity periodically
pays to the bondholder.

At a premium – if the sales price is more than the face value of the bonds, the bonds are said to be sold at a premium. The bond
premium is in effect a gain on the part of the issuing entity because it receives more than what it is obligated to pay under the terms of
the bonds.

At a discount – if the sales price of the bonds is less than the face value, the bonds are said to be sold at discount. The bond discount
is in effect a loss to the issuing entity

Bonds are sold at

• Face Value = Nominal rate = Effective rate

•Premium = Nominal rate > Effective rate
• Discount = Nominal rate < Effective rate

The nominal rate of interest is the rate appearing on the face of the bond certificate. It is that interest which the
issuing entity periodically pays to the bondholder.

The bond premium or discount is not reported as outright gain or loss but instead subject for amortization over
the life of the bonds and credited/debited to interest expenses.

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 Measurement of bonds payable

At initial measurement - PAS 39

provides that bond issued costs
shall be included in the initial
measurement of financial liability. &
shall be presented as a deduction
Subsequently measured of bonds - at
from bonds payable. Under the amortized cost using the effective
The discount on bond payable is a The premium on bond payable is an
effective interest method of interest method of which discount
deduction from the bond payable addition to the bond payable.
amortization, or premium are reported as
adjustments to the bond payable
• the bond issue cost must be lumped with the
discount on bonds payable
• The bond issue cost must be netted against
the premiums on bonds payable.

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 Kinds of Bonds issued
With shares warrants – when the bonds
are sold with shares warrants, the
• Detachable warrants can be traded
bondholders are given the right to
acquire shares of the issuing entity at a
separately from the bond
specified price at some future time.
Share warrants may be detachable or
• Non-detachable warrants cannot be
non-detachable traded separately

Convertible – are those bonds which

give the holders thereof the right to
convert their bondholding into share
capital within a specified period of time.
When bonds are issued at a premium or
discount, amortization period is up to
the maturity date instead of the
conversion date because it is impossible
to predict that the conversion privilege
will be exercise

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 Accounting problems arising from convertible bonds
• PAS 32 mandates that the issuer of a compound financial instrument shall classify the liability and equity
components separately.
When the convertible
bonds are originally • The bonds are assigned an amount equal to the market value of the bonds without the conversion privilege and the
issued - Bonds issue with
share warrants are
residual amount of the issue price shall be allocated to the conversion privilege or equity component
considered as compound
financial instrument.

• The standard states that the book value of the bonds is the measure of the share capital issued.
• Any cost incurred in the bond conversion shall be deducted from share premium if any, otherwise, it is treated as
When the convertible expense
bonds are converted –
the accounting problem • The book value of the bonds is equal to the face value plus accrued interest (if not paid) plus /minus unamortized
is the determination of a premium or discount and bond issued cost
value to be assigned to
the share capital issued.

Conversion of bonds
shall be treated as
premature retirement of
bonds but no gains or
loss is recognized..

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 Methods of amortization
Straight line method – the straight line method
provides for an equal amortization of bond
premium or discount.

Bond outstanding method – this method is

applicable to serial bonds. This approach gives
recognition to the diminishing balance of the
bonds. This is based on the theory that interest
expense shall decrease every year by reason of the
decreasing principal balance.

Effective interest method or interest method or

scientific method – this method distinguish 2
kinds of interest rate, namely the nominal rate
and effective rate. The nominal rate is also
known as the coupon or stated rate. The
effective rate also known as yield or market rate.

• Nominal rate Or Int. paid (Nominal rate x FV) xx

Computation of amortization • Less: Effective rate or Int. exp. (effective rate x BV) xx
• Premium / (Discount) amortization xx/(xx)

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 Operating lease
 PAS 17 defined lease as “an agreement whereby the lessor conveys to the lessee in return for a
payment or series of payments the right to use an asset for an agreed period of times.”

 Treatment Lessee Lessor

− Rental Rent exp Rent income
− Security deposit Rent deposit Liab 4 rent deposit
− Lease bonus Prepaid rent Unearned rent
− Amort of lease bonus Rent exp Rent income
− Direct cost None Deferred exp
− Repair & maint Expense Expense
− Depreciation none Expense
− Amort of direct cost None Expense

 Unequal rental payments - this means that where the operating lease requires unequal cash
payments, the total cash payments for the lease term shall be amortized uniformly on the
straight line basis as rent expense or rent income.

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 Definition of Sales & Leaseback
A sale & leaseback is an arrangement whereby one
party sells a property to another party and then
immediately leases the property back from its new
owner. The accounting treatment of a sale &
leaseback transaction depends upon the types of
the lease involved either as leaseback as an
operating lease or finance lease.

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 Leaseback as an operating lease
• If the sale and leaseback transaction is clearly established at fair value, any gain
PAS 17 provides the following or loss on sale and leaseback shall be recognized immediately. The transaction is
rules if the leaseback is an established at fair value when the sales price is equal to the fair value.
operating lease: • If the sales price is equal or below fair value, any gain or loss shall be recognized
immediately

• Cash received from sales xx

Formula • Less: BV of asset sold xx
• Gain from sales xx

If the sales price is above fair

value, the excess over fair value
is deferred and amortized over
the period for which the asset
is expected to be used.

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 Leaseback as a finance lease
 PAS 17 provides that “if the sale and leaseback transaction
results in a finance lease, any excess of sale proceeds over
the carrying amounts should not be immediately
recognized as income but deferred and amortized over the
lease term but any loss on sale and leaseback is recognized
immediately.”

 A finance lease is defined as in substance an installment

purchase of an asset by the lessee from the lessor.

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