CHAPTER 1

LIABILITIES

TECHNICAL KNOWLEDGE

To understand the concept of liabilities.

To describe the nature and type of current and noncurrent liabilities.

To know the measurement of current and noncurrent liabilities.

To explain the issue of long-term debt falling due within one year.

To explain the issue of breach of covenants attached to a long-term debt.

To describe formulas in computing bonus to officers and employees.

LIABILITIES
The Revised Conceptual Framework for Financial Reporting provides the
following definition of liabilities.
Liabilities are present obligations of an entity to transfer an economic
resource as a result of past events.

Accordingly, the essential characteristics of an accounting liability are:

a. The entity has a present obligation
An obligation is a duty or responsibility that an entity has no practical
ability to avoid.
The entity liable must be identified but it is not necessary that the
payee to whom the obligation is owed be identified.

b. The obligation is to transfer an economic resource

This is the very heart of the definition of an accounting liability.
The economic resource is the asset that represents a right with a
potential to produce economic benefits.
Specifically, the obligation must be to pay cash, transfer noncash asset
or provide service at some future time.

c. The liability arises from a past event.

This means that the liability is not recognized until it is incurred.
Present obligation

An essential characteristic of a liability is that the entity has a present

obligation.
The present obligation may be a legal obligation or a constructive
obligation.

Obligations may be legally enforceable as a consequence of binding

contract or statutory requirement.
This is normally the case, for example, with accounts payable for goods
and services received.

Constructive obligations also give rise to liabilities by reason of normal

business practice, custom and a desire to maintain good business relations
or act in an equitable manner.

Transfer of an economic resource.

Without payment of money, without transfer of noncash asset, without

performance of service, there is no accounting liability.

A crystallization of the definitive concept of an accounting liability is when

an entity declares cash dividend.

In such a cash, there is an obligation to pay cash, hence, accounting

liability exists.

But when an entity declares share dividend, there is no accounting

liability.

The obligation is to issue the entity’s own shares.

The issuance of the entity’s own shares is not a transfer of noncash asset
because the share capital is an equity item.

Thus, share dividend payable is classified as part of equity rather than

accounting liability
Past event

Another essential characteristic of a liability is that the liability must arise

from a past transaction or event.

The past event that leads to a legal or constructive obligation is known as

the obligating event.

The obligating event creates a present obligation because the entity has
no realistic alternative but to settle the obligation created by the event.

For example, the acquisition of goods gives rise to accounts payable. The
obligating event is the acquisition of goods.

The receipt of a bank loan results in an obligation to repay the loan.

The obligating event is the cash received from the bank as a consequence
of the bank loan.

Examples of liabilities
The more common types of liabilities include the following:

a. Accounts payable to suppliers for the purchase of goods

b. Amounts withheld from employees for taxes and for contributions to
the Social Security System
c. Accruals for salaries, interest, rent, taxes, product warranties and profit
-sharing bonus
d. Cash dividends declared but not paid.
e. Deposits and advances from customers
f. Debt obligations for borrowed funds – notes, mortgages and bonds
payable
g. Income tax payable
h. Unearned Revenue
Measurement of current liabilities

Conceptually, all liabilities are initially measured at present value and

subsequently measured at amortized cost.

However, in practice, current liabilities or short-term obligations are not

discounted anymore but measured, recorded and reported at their face
amount.

The reason is that the discount or the difference between the face amount
and the present value is usually not material and therefore ignored.

Measurement of noncurrent liabilities

Noncurrent liabilities, for example, bonds payable and noninterest-bearing

note payable, are initially measured at present value and subsequently
measured at amortized cost.

If the long-term note payable is interest-bearing, it is initially and

subsequently measured at face amount.

In this case, the face amount is equal to the present value of the note
payable.

The “amortized cost measurement” is taken up in a later chapter in

relation to bonds payable.
Current Liabilities

PAS 1, paragraph 69, provides that an entity shall classify a liability as a

current when:

a. The entity expects to settle the liability 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 settle within twelve months after the
reporting period.
d. The entity does not have an unconditional right to defer settlement
of the liability for at least twelve months after the reporting period.

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

Such operating items are classified as current liabilities even if settled

more than twelve months after the reporting period.

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 reporting
period or held primarily for the purpose of trading.

Examples of such current liabilities are financial liabilities held for trading,
bank overdraft, dividends payable, income taxes, other nontrade payables
and current portion of noncurrent financial liabilities.

Financial liabilities held for trading are financial liabilities that are incurred
with an intention to repurchase them in near term
An example is a quoted debt instrument that the issuer may buy back in
near term depending on changes in fair value.

Noncurrent Liabilities

The term noncurrent liabilities is a residual definition.

All liabilities not classified as current are classified as noncurrent liabilities.

Noncurrent Liabilities include:

a. Noncurrent portion of a long-term debt

b. Finance lease liability
c. Deferred tax liability
d. Long-term obligation to officers
e. Long-term deferred revenue

Long-term debt falling due within one year

A liability which is due to be settle within twelve months after the reporting
period is classified as current, even if:

a. The original term was for a period longer than twelve months
b. An 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.

However, if the refinancing on a long-term basis is completed on or

before the end of the reporting period, the refinancing is an adjusting
event and therefore the obligation is classified as noncurrent.

Moreover, if the entity has the discretion to refinance or roll over an

obligation for at least twelve months after the reporting period under an
existing loan facility, the obligation is classified as noncurrent even if it
would otherwise be due within a shorter period.

If the entity has an unconditional right under the existing loan facility
to defer the settlement of the liability for at least twelve months after the
reporting period, the obligation is considered part of the entity’s long-term
refinancing.

Note that the refinancing or rolling over must be at the discretion of the
entity.

Covenants

Covenants are often attached to borrowing agreements which represent

undertakings by the borrower.

These covenants are usually restrictions on the borrower as to

undertaking further borrowings, paying dividends, maintaining specified
level of working capital and so forth.

Breach of covenants

Under these covenants, if certain conditions relating to the borrower’s

financial situation are breached, the liability becomes payable on demand.

PAS 1, paragraph 74, provides that such a liability is classified as current

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.
This 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 twelve months after that date.

However, the liability is classified as noncurrent if the lender has agreed

on or before the end of reporting period to provide a grace period
ending at least twelve months before that date.

In this context, a grace period is a period within which the entity can
rectify the breach and during which the lender cannot demand
immediate repayment.

Presentation of the current liabilities

Under Paragraph 54 of PAS 1, as a minimum, the face of the statement

of financial position shall include the following line items for the current
liabilities:

a. Trade and other payables

b. Current provisions
c. Short-term borrowing
d. Current portion of long-term debt
e. Current tax liability

The term trade and other payables is a line item for accounts payable,
notes payable, accrued interest on note payable, dividends payable and
accrued expenses.

No objection can be raised if the trade accounts and notes payable are
separately presented.
Estimated liabilities

Estimated liabilities are obligations which exist at the end of reporting

period although their amount is not definite.

In many cases, the date when the obligation is due not also definite and,
in some instances, the exact payee cannot be identified or determined.

But in spite of these circumstances, the existence of the estimated

liabilities is valid and unquestioned.

Estimated liabilities are either current or noncurrent in nature.

Examples include estimated liability for premium, award points,

warranties, gift certificates and bonus.

Deferred Revenue

Deferred revenue or unearned revenue is income already received but not

yet earned.

Deferred revenue may be realizable within one year or in more than one
year after the end of the reporting period.

If the deferred revenue is realizable within one year, it is a current

liability.

Typical examples of current deferred revenue are unearned interest

income, unearned rental income and unearned subscription revenue.

If the deferred revenue is realizable in more than one year, it is classified

as a noncurrent liability.
Typical examples of noncurrent deferred revenue are unearned revenue
from long-term service contracts and long-term leasehold advances.

Illustration

An entity sells equipment service contracts agreeing to service equipment

for a 2-year period.

Cash receipts from contracts are credited to unearned service revenue

and service contract costs are charge to service contract expense.

Revenue from 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 contract costs paid 500,000
Service contract revenue recognized 800,000

Journal Entries for the first year

1. To record the cash receipts from contracts sold:

Cash 1,000,000
Unearned 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 revenue 800,000

Gift certificates payable

Many megamalls, department stores and supermarkets sell gift certificates

which are redeemable in merchandise. The accounting procedures are

1. When the gift certificates are sold:

Cash xx
Gift certificates payable xx
The latter account is a current liability

2. When the gift certificates are redeemed:

Gift certificates payable xx
Sales xx

3. When the gift certificates expire or when the gift certificates are not
redeemed.
Gift certificates payable xx
Forfeited gift certificates xx

The Philippine Department of Trade and Industry ruled that gift certificate
no longer have an expiration period.
Bonus computation

Large entities often compensate key officers and employees by way of

bonus for superior income realized during the year.

The main purpose of this scheme is to motivate officers and employees

by directly relating their well-being to the success of the entity.

This compensation plan results in liability that must be measured and

reported in the financial statements. The bonus computation usually has
four variations:

1. Bonus is expressed as a certain percent of income before bonus and

before tax

2. Bonus is expressed as a certain percent of income after bonus but

before tax

3. Bonus is expressed as a certain percent of income after bonus and

after tax

4. Bonus is expressed as a certain percent of income after tax but before

bonus.
Illustration

Income before bonus and before tax 4,400,000

Bonus 10%
Income tax rate 30%

Case 1 – Before bonus and before tax

Income before bonus and before tax 4,400,000

Multiply by 10%
Bonus 440,000

Case 2 – After bonus but before tax

B = .10 (4,400,000 – B)
B = 440,000 - .10B
B + .10B = 440,000
1.10B = 440,000
B = 440,000/1.10
B = 400,000
Proof

Income before bonus and before tax 4,400,000

Less: Bonus 400,000
Income after bonus but before tax 4,000,000
Multiply by 10%
Bonus 400,000

Case 3 – After bonus and after tax

B = .10 (4,400,000 – B – T)
B = .30 (4,400,000 – B)
B = .10 [4,400,000 – B - .30 (4,400,000 – B)]
B = 440,000 - .10B – 132,000 + .03B
B + .10B – .03B = 440,000 – 132,000
1.07b = 308,000
B = 308,000 /1.07
B = 287,850
T = .30 (4,400,000 – 287,850)
T = 1,233,645
Proof

Income before bonus and before tax 4,400,000

Bonus ( 287,850)
Tax ( 1,233,645)
Income after bonus and after tax 2,878,505
Multiply by 10%
Bonus 287,850

Case 4 – After tax but before bonus

B = .10 (4,400,000 – T)
B = .30 (4,400,000 – B)
B = .10 [4,400,000 - .30 (4,400,000 – B)]
B = .10 (4,400,000 – 1,320,000 + .30B)
B = 440,000 – 132,000 + .03B
B - .03B = 440,000 – 132,000
.97B = 308,000
B = 308,000 / .97
B = 317,526
Proof
Income before bonus and before tax 4,400,000
Tax (4,400,000 – 317,526 x 30%) 1,224,742
Income after tax but before bonus 3,175,258
Multiply by 10%
Bonus 317,526

Refundable Deposits

Refundable deposits consist of cash or property received from customers

but which are refundable after compliance with certain conditions.

The best example of refundable deposit is the customer deposit required

for returnable containers like bottles, drums, tanks and barrels.
Illustration

A deposit of P10,000 is required from the customer for returnable

containers. The containers cost P8,000

Cash 10,000
Containers’ deposit 10,000

The containers’ deposit account is usually classified as current liability.

If the customer returns the containers, the deposit is simply refunded.

However, if the customer fails to return the containers, the deposit is

considered the sale price of the containers.

The excess of the deposit over the cost of the containers is considered as
a gain.

Questions

1. Define liabilities.

2. What are the essential characteristics of an accounting liability?

3. Explain a present obligation.

4. Explain transfer of an economic resource to settle an obligation.

5. Explain a past event that leads to a present obligation.

6. Explain the measurement of current and noncurrent liabilities.

7. Define current and noncurrent liabilities.

8. Explain the refinancing of a long-term debt falling due within one

year.

9. What are covenants attached to borrowing agreements?

10. How are current liabilities presented in the statement of financial
position?

11. What are estimated liabilities?

12.What is a deferred revenue?

13.Explain gift certificates payable

14.What are refundable deposits

15.What are the four variations in the computations of bonus?