Chapter 8-2: Liabilities

Liability Measurement
 Under IFRS, the most commonly method to measure
liabilities is historical cost (or modified historical cost).
 Fair value measurement is used on the initial measurement
of transactions.
 In subsequent years, the liability is measured based on
amortised cost: cost of the liability at inception adjusted on a
yearly basis to reflect its estimated current value.
 See table 8.1 page 269.
Employee Benefits – pension plans
 Established by the employer to provide retirement benefits for
employees.
 A form of deferred compensation offered by the firm in exchange for
services by employees who have chosen, explicitly or implicitly, to
accept lower compensation in return for future pension payments.
 Employers make payment to pension funds (legal entities, separate
from the employer firm), which hold assets, to fund payment when
the employees retire.
 Pension plans may be:
contributory: employer and employee both contribute to the fund)
Non contributory: only the employers makes contributions
 Defined benefit funds: the amount to be paid to the employee are at
least partially a function of the employee’s final or average salary.
 Defined contribution funds: pays an amount that is a function of
the contributions made to the fund.
 Pension funds may be fully funded, partially funded or unfunded:
 Fully funded: have sufficient cash or investments to meet the fund’s
obligation to members.
 Unfunded: do not cash or investments to cover the potential payout
under the plans.
 The firms has an equitable obligation to meet unfunded commitment
 has a liability.
  Following IACS 37/AASB 137:
all provisions are contingent because they are uncertain in timing or
amount  meet all criteria b below
Provisions and Contingencies
Contingent liability is:
(a) A possible obligation that arises from past events and whose
existence will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly
within the control of the entity; OR
(b) A present obligation that arises from past events but is not
recognised because:
(i) It is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation; or
(ii) The amount of the obligation cannot be measured with sufficient
reliability.
Owners’ Equity
 Captures the owners’ claims against the entity’s net assets,
which the entity has no current obligation to pay.
 Its not an obligation to transfer assets, but a residual claim.
 A fundamental question to be addressed in arriving at the
amount of the equity is whether an item represents a liability
or equity of entity. Two features to distinguish:
The right of the parties
The economic substance of the arrangement.
 Rights of the creditors:
Settlement of their claims by a given date through a transfer of
Rights of the Parties
assets (goods or services)
Priority over owners in the settlement of their claims in the event of
liquidation.
 Creditors have a limited amount of claims.
 Owners have a residual interest only
 Creditors have no right to use the assets of the firm, except as
specified in contracts.
 Owners have the right/authority to operate the business.
Economic Substance
 Both liabilities and owners’ equity represent claims against
the entity.
 Creditor have a right to settlement, while owners have rights
to participate in profits.
 Creditors bear less risk and earn a relatively fixed return
( interest and settlement of the principal).
 Owners bear greater risk and earn a variable (of the higher)
rate of return, and have control of the acquisition,
composition, use and disposition of the firm’s assets.
Concept of Capital
 The framework recognises that whether or not a firm
maintain its capital intact is a function not only of the
definition of equity as a residual interest in an entity, but also
of the concept of capital.
 Capital can be conceptualised as: the invested money or
invested purchasing power (financial capital) or as the
productive capacity of the entity (physical capital).
 Capital can be measured in a nominal dollar or a purchasing
power (real) scale).
 Another objective of capital maintenance is to protect
creditors it is not a guarantee for the protection of
creditors, but it does offer some safety.
 Example: entity has legal capital $10,000. If total assets are
$100,000 liabilities are $90,000. If entity were to be
liquidated and the carrying amount of the assets realised
only $80,000; there would be enough to pay the creditors,
because the company has capital $10,000.
Classification within owners’ equity
 The rationale for separating the contributed and earning
capital is to keep separate the amount invested from the
amount that is reinvested:
 Contributed capital: from financing transaction.
 Earning capital: from profit-directed activities.
 R/E, or unappropriated profits, make up the earned capital
Challenges for Standard Setters
 1. Debt vs Equity Distinction:
 Shares issued to investors form part of equity; loans from
creditors are liabilities.
 Convertible bonds and preference share have regarded as
equity, but they have characteristics that also align them to
liabilities see page 275
2. Extinguishing Debt
 The economic substance of the transaction involved in
placing risk-free assets (e.g. government securities) or cash
in an irrevocable trust for the purpose of payment of the debt
is tantamount of the existing debt it is potentially
misleading that the debt is not shown on B/S.