CURRENT LIABILITIES TOPIC OUTLINE Definition Liabilities Essential Characteristics CURRENT LIABILITES Measurement Current Liabilities Classification Non-current Liabilities LECTURE NOTES LIABILITIES 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. Essential Characteristics of Liabilities: 1. Liabilities are PRESENT OBLIGATION. It is NOT NECESSARY that the payee to whom the obligation is owed be identified. What is important is that the entity identifies itself as liable to another entity. 2. Liabilities arise from PAST TRANSACTIONS OR EVENTS. This means that the liability is no recognized until it is incurred. The past event that leads to a present obligation is called an obligating event. An obligating event is an event that creates a legal (the settlement of the obligation can be enforced by law) or constructive obligation (The event creates valid expectation on the part of other parties that the entity will discharge the obligation, as in the case of constructive obligation) because the entity has no realistic alternative but to settle the obligation created by the event. 3. The settlement of the liability REQUIRES AN OUTFLOW of resources embodying economic benefits. Settlement may be in the form of: (a) payment of cash (b) transfer of non-cash assets; (c) provision of future services. This characteristic is the main reason why STOCK DIVIDENDS PAYABLE is NOT a LIABILITY but rather presented within EQUITY. MEASUREMENT CLASSIFICATION FINANCIAL LIABILITIES Financial Liabilities at Fair Value through Profit or Loss Financial Liabilities at Amortized Cost NON-FINANCIAL LIABILITIES INITIAL MEASUREMENT SUBSEQUENT MEASUREMENT AMORTIZED? FAIR VALUE CHANGES INTEREST EXPENSE IS BASED ON Nominal Rate Fair Value Fair Value No Yes (Presented in Profit or Loss) Fair Value minus Transaction Cost Amortized Cost Yes No Effective Rate Best Estimate of Cash Outflow Yes, if measured at present value No Usually, Effective Rate if the liability is measured at present value Best Estimate of Cash Outflow NOTES: a. Transaction costs are expensed immediately if the financial liability is designated initially as at fair value through profit or loss. Transaction costs are incremental costs that are directly attributable to the issue of a financial liability. b. Transaction costs include: Fees and commissions paid to agents, advisers, brokers and dealers Levies by regulatory agencies and securities exchanges Transfer taxes and duties Transaction costs do not include: Debt premiums or discounts Financing costs Internal administrative or holding cots c. Financial liabilities are classified as FVPL (1) through irrevocable designation or (2) if the liability is held for trading (liabilities with an intention to repurchase them in the near term) d. The “amortized cost” of a financial liability is the amount at which the financial liability is measured at initial recognition minus principal repayment, plus or minus the cumulative amortization using the effective interest method of any difference between the initial amount and the maturity amount. FINANCIAL STATEMENTS CLASSIFICATION An item of liability is classified as current liability if it met any of the following criteria set by PAS 1: 1. 2. 3. 4. The entity expects to settle the liability within the entity’s normal operating cycle. The entity holds the liability primarily for the purpose of trading. The liability is due to be settled within twelve months after the reporting period. The entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. NOTE: If an item did not meet any of the criteria above, it is classified as a non-current liability. Examples of CURRENT LIABILITIES: Trade and other payables (a) Financial liabilities held for trading Current portion of long-term debt Short-term borrowing Current provisions Current tax liability Financial liabilities held for trading Bank overdraft Credit balances in accounts receivable Unearned income realizable within 12 months (b) Accrued expenses Long-term debt currently maturing Refundable deposits (c) Payroll taxes payable (d) Value-added Taxes (VAT) payable (Output VAT less Input VAT) Escrow liability (e) Note: Non-trade payables are classified as current liabilities if are due for settlement within twelve months after the reporting period or held primarily for the purpose of being traded. REFINANCING OF CURRENTLY MATURING OBLIGATION GENERAL RULE: A currently maturing obligation is presented as CURRENT LIABILITY. EXCEPTIONS: (The liability is presented as NON-CURRENT LIABILITY if it met any of the following conditions) (1) The company has the prerogative/option/unconditional right to refinance the liability. (2) If there is no right but refinancing was completed on or before the balance sheet date. Refinancing may be done thru extension of maturity date or through issuance of bonds the proceeds of which is used to settle the currently maturing obligation. To provide a clear guidance on the above concept, please see the following concept map: With unconditional right to refinance the liability (NONCURRENT LIABILITY) RULES ON REFINANCING Without unconditional right to refinance the liability But refinancing was made ON OR BEFORE year-end (NONCURRENT LIABILITY) But refinancing was made AFTER year-end (CURRENT LIABILITY) GENERAL RULE: If the company breached a covenant or contract, the long-term obligation BECOMES IMMEDIATELY DEMANDABLE, thus presented as a CURRENT LIABILITY. EXCEPTIONS: (The liability is still presented a NON-CURRENT LIABILITY under the following conditions) (1) If the creditor agreed to give the debtor a grace period for at least 12 months after the balance sheet date AND (2) The said grace period was provided on or before the balance sheet date. To provide a clear guidance on the above concept, please see the following concept map: BREACH OF CONTRACTS BREACH OF COVENANT No grace period was agreed upon (CURRENT LIABILITY) After balance sheet date (CURRENT LIABILITY) Grace period given was less than 12 months (CURRENT LIABILITY) Grace Period was agreed upon On or before balance sheet date Grace period given was equal or more than 12 months (NON-CURRENT LIABILITY) TRADE AND OTHER PAYABLES (a) The frequently asked question regarding trade accounts payable is its adjusted balance. As a guide in computing such, please see the below template: Solution Guide Unadjusted balance Add: Post-date checks and unreleased checks Debit balances in AP (If the unadjusted balance is a net amount Less: Unrecorded purchase returns and allowances Discounts forfeited (under net method) Effect of Freight terms Adjusted balance xx xx xx (xx) (xx) xx(xx) xx In relation to freight terms, please see the following guide: If the good were in transit to the entity and the freight term is o FOB Shipping Point- Accounts Payable and purchases should be increased. o FOB Destination- Ignore, purchases and accounts payable should be increased upon arrival of the goods. In relation to freight cost, its effect on accounts payable depends on the freight terms as well and are summarized below: Effect on Accounts Payable? FOB Shipping Point, Freight Collect No effect FOB Shipping Point, Freight Prepaid Increase FOB Destination, Freight Prepaid No effect FOB Destination, Freight Collect Decrease UNEARNED INCOME(b) Deferred revenue or unearned revenue is income already received but not yet earned. Unearned income may come from: Goods (Advances from customers) Services (Unearned income from service contracts, unearned subscription revenue) Use of entity’s resources (Unearned interest income, unearned rental income) Deferred revenue may be realizable within one year or in more than one year from the end of reporting period. If the deferred revenue is realizable within one year, it is classified as 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 noncurrent liability. Typical examples of noncurrent deferred revenue are unearned revenue from long-term service contacts and long-term leasehold advances. In relation to unearned income, the frequently asked questions are (1) Earned portion (income); (2) Ending balance of unearned income. To answer such question, use the T-account in relation to unearned income: Unearned Income Earned Portion xx Beginning Balance Cash Receipts End. Balance For unearned income from gift certificates, please use the modified T-account: Gift Certificates Payable Redemption (whether Beginning Balance from prior year or current Cash Receipts from year sales) xx sales Expired Portion xx End. Balance xx xx xx xx xx xx REFUNDABLE DEPOSITS (c) Refundable deposits consist of cash or property received from customers but which are refundable after compliance with certain conditions. The Frequently asked question regarding refundable deposits would be its ending balance at balance sheet data. Use the Following T-account as guide in answering such questions: Liability for Deposits Deposits returned Beginning Balance Applied xx Cash Receipts Deposits cancelled xx Deposits Expired xx End. Balance xx xx xx PAYROLL TAXES PAYABLE (d) Under our law, the entity as an employer is required to withhold from the salaries of each employee the following: (a) Income tax payable by the employee (b) Employee’s contribution to the Social Security System or SSS (c) Employee’s contribution for Philhealth (d) Employee’s contribution to the Pag-ibig Fund Such amounts withheld from the salaries of the employees shall be recognized as “payroll taxes payable” until remitted by the entity to the appropriate government authority. In addition to the amounts withheld from the salaries of the employees, the entity is required by law to make a contribution for SSS. ESCROW LIABILITY (e) Escrow is the use of a third party, which holds an asset or funds before they are transferred from one party to another. The third party holds the funds until both parties have fulfilled their contractual requirements. The frequently asked question regarding escrow liability is its ending balance. To help in solving such, please use the following T-Account: ESCROW LIABILITY Cash transfer or payments xx Beginning Balance Interest and other charges paid xx Cash Receipts Interest income End. Balance xx xx xx xx