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CHAPTER 1Current Liabilities, Provisions, andContingencies__________________________________Learning ObjectivesAfter reading this chapter, you should be able to1. define liabilities and explain their essential characteristics;2. identify the recognition criteria for liabilities;3. distinguish curren...

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CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

CHAPTER 1 Current Liabilities, Provisions, and Contingencies __________________________________ Learning Objectives

After reading this chapter, you should be able to 1. define liabilities and explain their essential characteristics; 2. identify the recognition criteria for liabilities; 3. distinguish current liabilities from non-current liabilities; 4. distinguish provision from contingent liabilities; 5. account for different liabilities after initial recognition; 6. measure current liabilities on the statement of financial position; and 7. identify required disclosure for current liabilities and contingencies .

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

DEFINITION AND NATURE OF LIABILITIES The IASB’s Conceptual Framework for Financial Reporting defines liability as “present obligation of an enterprise arising from past event, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.” An obligation is a duty or responsibility to act or perform in a certain way which may be legally enforceable as a consequence of a binding contract or statutory requirement; or it may be an obligation acknowledge by an enterprise because other parties are made to believe that it will carry out an undertaking or certain action. An obligating event is one that results in an enterprise having no realistic alternative to settling that obligation. An obligating event may be classified in either of the following: 1. legal obligation or 2. constructive obligation A legal obligation is one that derives from a contract (through its explicit or implicit term), legislation, or other operation of law. Examples of liabilities that arise from legal obligations are accounts payable (arising from a contract with a supplier), withholding taxes payable and value added taxes payable (arising from legislation and other operation of law). A constructive obligation is one that derives from an enterprise’s actions whereby an established pattern of past practice, published policies or a sufficiently specific current statement, the enterprise has indicated to other parties that it will accept certain responsibilities, and as a result, the enterprise has created a valid expectation on the part of those other parties that it will discharge those responsibilities. Example of a constructive obligation is provision for clean up costs where the enterprise has a widely published policy of cleaning up all contamination that it causes. The settlement of a present obligation involves the enterprise giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in any of the following ways: a. payment of cash; b. transfer to other assets; c. provision of services; d. replacement of an obligation with another obligation; and e. conversion of the obligation to equity. In some exceptional cases, an obligation is settled through condonation by the creditor.

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

An obligation always involves another party to whom the obligation is owed. However, it is not necessary to know the identity of the party to whom the obligation is owed for it to qualify as a liability. RECOGNITION OF LIABILITIES A liability is recoded and reported in the statement of financial position when the following conditions are met: 1. It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation; and 2. The amount at which the settlement will take place can be measured reliably. An outflow of resources is considered probable when the event is more likely to occur than not to occur (i.e., the probability of occurrence is more than 50%). Provision Distinguish from Contingent Liabilities

Definition

Provision Liability of uncertain timing or amount

Recognition Recognized as a liability on the face of the statement of financial position. Financial Presented separately in the Statement statement of financial Presentation position under liabilities

Contingent Liability Either 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 future events not wholly within the control of the enterprise; or b) a present obligation that arises from past events but is not recognized because  it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or  the amount of the obligation cannot be measured reliably. Not recognized as a liability on the face of the statement of financial position. Unless remote, disclosed in the notes to financial statements

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

Obligation involving uncertainties are accounted for as presented below: Record by debiting an expense or a loss and crediting a liability

STATUS Reliably measure Not reliably measure

Probable Reasonably Possible Remote

Disclose in the notes to financial statements

Ignore (Neither recognize nor disclose)

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Contingent liabilities must be assessed continually to determine whether an outflow of resources embodying economic benefits has become probable. If it becomes probable that an outflow of future economic benefits will be required for an item previously dealt with as a contingent liability, a provision is recognize in the financial statements of the period in the change in probability occur (except in the extremely rare circumstances where no reliable estimate can be made). MEASUREMENT OF LIABILITIES Liabilities are measured 1. at the amounts in exchanges (amount to be paid or amount discounted); or 2. by estimates of a definitive character when the amount of the liability cannot be measured more precisely (provisions). Measurement of Provisions 

The amount recognized as a provision should be the best estimate of the expenditure required to settle the obligation at the end of the reporting period, considering * judgment of the management of the enterprise; * experience of similar transactions; or * reports from independent experts.

 

If a single obligation is being measured, the amount to be recognized as liability is the most likely outcome. Where the amount of the obligation is still uncertain as of the end of the reporting period, but the obligation is settled subsequently before the

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES



 

issuance of the financial statements, the amount shown in the statement of financial position is the amount actually settled subsequently. Where the provision being measured involved a large population of items, the obligation is estimated by weighting all possible outcomes by their associated possibilities. Where 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. Where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditures expected to be required to settle the obligation. Where some or all of the expenditures required to settle a provision is expected to be reimbursed by another party, the reimbursement should be recognized when, and only when, it is virtually certain that reimbursement will be received if the enterprise settles the obligation. The reimbursement, if virtually certain, should be treated as a separate asset. The amount recognized for the reimbursement should not exceed the amount of the provision.

Review of the Amount Previously Recognized as Provision If based on subsequent review of the amount of the provision, there is a need to adjust the previously recorded amount, the adjustment is treated as a change in accounting estimate and would affect profit or loss of the current year. Thus, if based on the review of the provision, the amount need to be decreased, the entry in a subsequent reporting period is to debit the provision and credit an appropriate expense, loss or in some cases, an income account. If at the end of the reporting period, it is no longer probable that an outflow of resources will be required to settle the obligation, the provision previously recognized should be reversed.

CLASSIFICATION OF LIABILITIES An enterprise shall classify a liability as current when (par. 69, IAS 1): a. it expects to settle the liability in its normal operating cycle; b. it holds the liability primarily for the purpose of trading; c. the liability is due to be settled within twelve months after the reporting period; or d. it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period.

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

Trade payables are generally classified as current liabilities even if they are not due for settlement within twelve months from the end of the reporting period, because settlement of these obligations is expected within the entity’s normal operating cycle. Some liabilities include in this type are trade accounts and notes payable extended within the usual credit terms of the supplier, and accruals for employee’s wages and other operating costs. No-trade obligations that are due for settlement within twelve months from the end of the reporting period (regardless of the length of the operating cycle of the entity) also form a part of current liabilities. These include short-term non-trade notes payable; deposits and advances and portion of long term debt due within 12 months from the reporting date. Liabilities are held for trading if they are incurred principally for the purpose of selling or repurchasing in the near term, or are part of the portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern of actual profit-taking. These type of liabilities include deposits received by banks which are held under trust funds and are invested by banks, in behalf of the depositors, in some short-term financial instruments. Liabilities held for trading also include derivatives. A long-term liability maturing within twelve months from the reporting date is generally classified as part of current liabilities. However, if at the reporting date, the entity has the right to defer settlement of the obligation for a period of more than twelve months from such date, the liability shall be classified as non-current. The right to postpone the settlement of the obligation may arise because of refinancing agreement entered into by the enterprise. Refinancing takes the form of either extending the maturity date or entering into a borrowing transaction, proceeds of which will be used to settle the maturing obligation. The currently maturing obligation shall be reported as non-current only if the agreement to refinance is completed on or before the reporting date. If the agreement to refinance is completed after the reporting period, even before the issuance of the financial statements, the maturing obligation shall be classified as current, because as of the end of the reporting date, the enterprise has no right yet to defer the settlement of the liability. Likewise, if an entity expects, and has the discretion, to refinance or roll over an obligation for more than twelve months after the reporting date under an existing loan facility, it classifies the obligation as non-current, even if it would be due within a short period. Furthermore, when an entity breaches an undertaking under a long-term loan agreement on or before the reporting 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 reporting period and before the authorization of the financial statement for issue, not to demand payment as a current because, at the reporting date, the entity does not have an unconditional right to defer its settlement for at least twelve months after that date.

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

However, the liability is classified as non-current if the lender agreed at or before the reporting date to provide a grace period ending at least twelve months from that date, within which the entity can rectify the breach and during which the lender cannot demand immediate payment. Presentation Based on Liquidity Assets and liabilities are classified into current and non-current on the face of the financial statement (general rule). An exception to this rule applies when the enterprise believes that presentation based on liquidity provides information that is more reliable and more relevant. When this exception applies, an entity shall present all assets and liabilities in order of liquidity. Whichever method is adopted for the presentation of assets and liabilities, IAS 1 requires for each asset and liability that combines 1). Amounts expected to be recovered or settled within twelve months from the reporting date and 2). Amounts expected to be recovered or settled more than twelve months after the reporting date disclosure of that amount expected to be recovered or settled after more than twelve months. EXAMPLES OF CURRENT LIABILITIES The major items usually found under the current liabilities section of the statement of financial position include:      

Accounts Payable Short-term Notes Payable Acceptance Payable Liabilities Under Trust Receipt Deposits and Advances Current Portion of Longterm Debt

     

Accrued Liabilities Income Tax Payable Dividends Payable Credit Balances in Costumer’s Account Deferred Revenue Provision expected to be settled within 12 months

EXAMPLES OF NON-CURRENT LIABILITIES All liabilities not classified as current are non-current liabilities. These include obligations arising from financing of long-term needs such as: 

Bonds Payable

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

Mortgage Loans Payable

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

Long Term Notes Payable

Liability under Finance Leases not due within 12 months Long-term Deferred Revenue

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

ACCOUNTING FOR DIFFERENT CURRENT LIABILITIES

ACCOUNTS PAYABLE A liabilities arising from the purchase of goods, materials, or services on an open charge-account basis is called accounts payable or trade accounts payable. The credit time period generally varies from 30 to 120 days without any interest being charged on the deferred payment. Most accounting system is designed to record liabilities for purchases of goods are received, or particularly, when the invoices are received from the supplier. Methods of Accounting for Cash Discounts Net method Purchases and Accounts Payable are initially recorded at invoice price less the cash discount available. A cash discount not taken is recorded as purchase discount lost, which is reported in profit or loss as part of finance cost.

Gross method Purchases account and the Accounts Payable are recorded at the gross invoice price. A cash discount taken on purchases is recorded upon payment as purchase discount. Any balance of purchase discounts is reported in profit or loss as deduction from gross purchases.

NOTES PAYABLE Note Bearing a Realistic Interest Rate A promissory note is a written promise to pay a certain sum of money to the bearer at a designated future time. The notes may arise out of either a trade situation (purchase of goods or services on credit) or the borrowing of money from a bank, or other transactions. Accounting for the issuance of interest bearing note is relatively straightforward. Since the note is interest bearing (and assuming that the stated rate approximates the prevailing market rate for similar obligations), the present value of the note at the time of its issuance is its face value. The issuance of such a note is recorded as follows (assume an issuance in settlement of an overdue trade discount): Accounts Payable Notes Payable

XX XX

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

At maturity date, payment is made for the principal amount plus interest for the entire term of the note, as follows: Notes Payable Interest Expense Cash

XX XX XX

If the note is still outstanding at the end of the accounting period, an accrued interest should be recorded for the period from the date of issuance of the note to the end of the accounting period. Accrual of interest is recorded as Interest Expense Interest Payable

XX XX

This adjusting entry may be reversed at the beginning of the new accounting period so that the subsequent payment of the note and interest may be recorded in the usual manner, debiting Notes Payable for the principal and Interest Expense for the total interest paid. Non – Interest Bearing Note Accounting for a non-interest-bearing note is slightly more complex. A noninterest-bearing note does not explicitly state an interest rate on the face of the note. It does not mean, that there is no interest imputed on the original obligation. A non-interest bearing note is simply written in a form where the interest is imputed on the face value of the note. Thus, the face value represents the present value of the obligation plus the imputed interest for the term of the note. The present value of the non-interest bearing note is the amount of cash received, or the fair value of goods and services received. If the note is issued in exchange for goods and services whose fair value cannot be reliably determined, the note is initially measured based on the prevailing market rate of interest for a similar obligation. The discounted amount (face value less an imputed interest) of the note should be used initially to record the liability. The Notes Payable account is credited equal to the face value of the note and a corresponding debit is made to the account Discount on Notes Payable. The net credit account (Notes Payable less Discount on Notes Payable) is the initial amortized cost of the liability. Interest expense is then recognized over the term of the note, using the effective interest method, as an adjustment of this discounted amount. This is done by charging Interest Expense and crediting Discount on Notes Payable. At reporting date, the balance of discount on notes payable is deducted from the dace value of the note to arrive at the amortized cost of the note to be presented on the statement of financial position. The balance of the discount represents interest expense over the remaining term of the note.

CHAPTER 1: CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

Note Bearing an Unrealistic Interest Rate When the interest rate appearing on the face of the note is significantly different from the market rate of similar notes, or when the consideration received on account of the note issued has a fair value which is significantly different from the face value of the note, the note bears an unrealistic interest rate. In such cases, the note and the interest to be paid based on the stated rate are discounted at the market rate of interest on the date of the issuance. If the rate stated on the face of the note is higher than the market rate of interest, the discounted amount is higher than the face value of the note, resulting in premium on notes payable. It the rate stated on the face of the note is lower than the market rate of interest; the discounted amount is lower than the note’s face value, resulting in discount on notes payable. STATED RATE < MARKET RATE = DISCOUNT STATED RATE > MARKET RATE = PREMIUM

ACCRUED LIABILITIES Accrued liabilities consist of obligations for expenses incurred on or before the end of the reporting...