Intermediate Accounting 2 1 Current Liabilities Module 001: Current Liabilities (Part 1) Course Learning Outcomes: At the end of this module, the student will 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. Definition and Nature of Liabilities “Liabilities are present obligations of the entity to transfer economic resource as a result of past events.” – The Conceptual Framework for Financial Reporting (March 2018) Essential characteristics of an accounting liability are: a. The liability is the present obligation of a particular entity. b. The liability arises from past transaction or event. c. The settlement of the liability requires an outflow of resources embodying economic benefits. Settlement may occur in a number of ways, such as by: - Payment of cash - Transfer of other assets - Provision of services - Replacement of an obligation with another obligation or - Conversion of the obligation to equity Recognition of Liabilities A liability is recorded 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. In cases when only one of the conditions for recognition of liability is met by an item of an element, no recognition of liability is made on the financial statements. Measurement of Liabilities Philippine Accounting Standards (PAS) 39 states that when a financial liability is recognized initially, an entity shall measure it at its fair value plus, in the case of a financial liability not a fair value through profit or loss, transaction costs that are directly Course Module attributable to the issue of the financial liability. After initial recognition, an entity shall measure a financial liability at amortized cost. The fair value of the liability is equal to the present value of 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. Conceptually, all liabilities are measured at present value or discounted amount. Examples of Liabilities a. Accounts payable to suppliers for the purchase of goods or services b. Amounts withheld from employees or other parties for taxes and for contributions to the Social Security System or to pension funds. c. Accruals for wages, interest, royalties, taxes, product warranties and profit sharing plans. d. Dividends (not stock dividends) declared but not paid e. Deposits and advances from customers, officers and shareholders f. Debt obligations for borrowed funds-notes, mortgages and bonds payable g. Income tax payable h. Unearned revenue Classification of Liabilities Under PAS 1 on presentation of financial statements, liabilities are classified into two, namely. 1. Current Liabilities PAS 1 provides that an entity shall classify a liability as current when: a. The entity expects to settle the liability within the entity’s operating cycle Trade payables and 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 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 are financial liabilities held for trading, bank overdraft, dividends payable, income taxes, other nontrade payables and current portion of noncurrent financial liabilities. b. The entity holds the liability primarily for the purpose of trading Financial liabilities held for trading are financial liabilities that are intended with an intention to repurchase them in the near term. An example is a quoted debt Intermediate Accounting 2 3 Current Liabilities instrument that the issuer may buy back in the near term depending on changes in fair value. c. The liability is due to be settled within 12 months after the reporting period d. The entity does not have unconditional right to defer settlement of the liability for at least twelve months after the reporting period. Measurement of Current Liabilities In practice, current liabilities or short-term obligations are not discounted anymore but measured, recorded and reported at their face amount. The reason for this is that the discount or the difference between the face amount and the present value is usually not material and therefore ignored. 2. Noncurrent liabilities All liabilities not classified as current are classified as noncurrent liabilities. These include: a. Noncurrent portion of long-term debt b. Finance lease liability c. Deferred tax liability d. Long-term obligation to entity officers e. Long-term deferred revenue Measurement of noncurrent liabilities Noncurrent liabilities or long-term obligations are measured at face amount or present value depending on whether they are interest-bearing or noninterest-bearing. If the noncurrent liability is interest-bearing, it is measured at face amount because in this case, the face amount is already the present value of the obligation. If the noncurrent liability is noninterest-bearing, it 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. The amortization of discount results in the subsequent measurement of a financial liability at “amortized cost”. A liability which is due to be settled 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. Course Module 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. The reason for this treatment is that the obligation is considered to form part of the entity’s long-term refinancing because the entity has an unconditional right under the existing loan facility to defer settlement of the liability for at least twelve months after the reporting period. The refinancing or rolling over must be at the discretion of the entity. If not, the obligation is classified as current liability. Covenants Covenants are often attached to borrowing agreements which represent undertakings by the borrower. Those covenants are actually 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 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 unconditional right to defer its 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 the reporting period to provide grace period ending at least twelve months after that date. Non-adjusting Events The following events, with respect to loans classified as current liabilities, occurring between the end of the reporting period and the date the financial statements are authorized for issue shall qualify for disclosure as non-adjusting events, meaning, the loans remain as current liabilities: Intermediate Accounting 2 5 Current Liabilities 1. Refinancing on a long-term basis 2. Rectification of a breach of a long-term loan agreement 3. The granting by the lender of a grace period to rectify a breach of a long-term loan agreement ending at least twelve months after the reporting period. 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 is 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, gift certificates and bonus. Under PAS 37, an estimated liability is considered as a provision which is both probable and measurable. Glossary Grace period: A period within which the entity can rectify the breach and during which the lender cannot demand immediate repayment. Liability: 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. Measurement: Assigning of peso amount to a financial statement element. Obligation: 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. Obligating event: An event that creates a legal obligation or a constructive obligation that results in an enterprise having no realistic alternative to settling the obligation. Legal obligation: Derives from a contract, legislation or other operation of law. Constructive obligation: Derives from an enterprise’s actions whereby an established pattern of past practice, published policies or sufficiently specific current statement. Probable: When an event is more likely to occur than not to occur. Course Module References and Supplementary Materials Books and Journals 1. Valix, C. T., Peralta, J. F., & Valix, C. M. (2017). Financial Accounting (2017 ed., Vol. 2). Manila, Philippines: GIC Enterprises & Co., Inc. 2. Cabrera, M. B., & Ocampo, R. R. (n.d.). Financial Accounting & Reporting - Standards & Application (2014-2015 ed., Vol. 2). Manila, Philippines: GIC Enterprises & Co., Inc. 3. PAS 39 - Financial Instruments: Recognition and Measurement 4. PAS 1 – Presentation of Financial Statements 5. Millan, Z.V.B., Intermediate Financial Accounting 2 (2016 edition). Baguio City, Philippines: Bandolin Enterprise Online Supplementary Reading Materials 1. Liability (financial accounting); https://en.wikipedia.org/wiki/Liability_(financial_accounting); October 7, 2019 2. Current liabilities (short-term liabilities); https://www.bdc.ca/en/articlestools/entrepreneur-toolkit/templatesbusinessguides/glossary/pages/currentliabilities.aspx; October 7, 2019 3. Basic Reporting of Liabilities; http://open.lib.umn.edu/financialaccounting/chapter/13-1-basicreportingofliabilities/; October 7, 2019 4. Current Liabilities; https://www.tutor2u.net/business/reference/current-liabilities; October 7, 2019 Online Instructional Videos 1. Current Liabilities: Definition & Examples; http://study.com/academy/lesson/currentliabilities-definition-examples-quiz.html; October 7, 2019
