International Financial Reporting Standards
Classification of
liabilities
Joint World Bank and IFRS Foundation
‘train the trainers’ workshop hosted by the
ECCB, 30 April to 4 May 2012
The views expressed in this presentation are those of the
presenter, not necessarily those of the IASB or IFRS Foundation.
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International Financial Reporting Standards
Concepts—
classification of liabilities
The views expressed in this presentation are those of the
presenter,
not necessarily those of the IASB or IFRS Foundation
© IFRS Foundation | 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Classification concepts
3
• Objective of financial reporting
• Financial statements portray financial effects of
transactions and events by:
– grouping into broad classes (the elements, eg
liability)
– sub-classify elements
• IAS 1
– application of IFRSs with additional disclosures
when necessary results in a fair presentation
(faithful representation of transactions, events and
conditions)
– don’t offset assets and liabilities or income and
expenses
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Classification concepts—assets
and claims
4
• Information about the nature and amounts of a
reporting entity’s economic resources and
claims can help users to identify the reporting
entity’s financial strengths and weaknesses.
• That information can help users to:
– assess the reporting entity’s liquidity and
solvency
– its needs for additional financing and how
successful it is likely to be in obtaining that
financing.
(CF.OB13)
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Classification concepts—claims
• Information about priorities and payment
requirements of existing claims helps users to
predict how future cash flows will be distributed
among those with a claim against the reporting
entity (CF.OB13)
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5
Concept—liability definition
6
A liability is defined as a:
• present obligation
• arising from a past event
• the settlement of which is expected to lead to
an outflow of future economic benefits from the
entity
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Concept—liability recognition
7
A liability is recognised when:
• it is probable that any future economic benefit
associated with the item will flow from the
entity; and
• the item has a value that can be measured with
reliability.
For some items that satisfy the definition of a liability,
significant judgement is required to evaluate whether
such items satisfy the recognition criteria. Individual
IFRSs provide principles and application guidance.
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International Financial Reporting Standards
Differentiating equity from
liabilities
The views expressed in this presentation are those of the
presenter,
not necessarily those of the IASB or IFRS Foundation
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IAS 32
Financial Instruments: Presentation
9
Liabilities and equity
• Differentiation between a financial liability and
equity depends on whether there is an
obligation to deliver cash (or some other
financial asset).
• However, note the exception for certain puttable
instruments.
• When a transaction will be settled in the
issuer’s own shares, classification depends on
whether the number of shares to be issued is
fixed or variable.
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IAS 32
Financial Instruments: Presentation
• The following are equity:
– Puttable instrument that entitles holder to pro
rata share of net assets on liquidation
– Instrument that is automatically redeemed if
an uncertain future event occurs or death or
retirement of holder
– Subordinated instrument payable only on
liquidation
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IAS 32
Financial Instruments: Presentation
• The following are liabilities:
– Instrument is payable on liquidation, but the
amount is subject to a maximum ceiling
– Entity is obliged to make payments before
liquidation – such as mandatory dividend
– Mandatorily redeemable preference shares
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IAS 32
Financial Instruments: Presentation
12
Compound financial instruments
• A compound financial instrument, such as a
convertible note, is split into equity and liability
components.
• When the instrument is issued, the equity
component is measured as the difference
between the fair value of the compound
instrument and the fair value of the liability
component.
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Example—compound financial
instrument
• Issuance of convertible debt - Example
– 1/1/X1 issue at par a 4% convertible bond, par and
maturity amount = 50,000, maturity in 5 years
– If no conversion feature, would have paid 6%
– Calculate present value of cash flows at 6%:
– PV 50,000 due in 5 years @ 6% = 37,363
– PV annuity 2,000/year 5 years @ 6% = 8,425
– Total PV = 45,788
Debit cash
50,000
Credit financial liability
Credit equity (conversion right)
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45,788
4,212
IAS 32
Financial Instruments: Presentation
14
Treatment of interest, dividends, gains and
losses
• Classification of a financial instrument as a
financial liability or equity determines the
treatment of the interest, dividends, losses or
gains on the financial instrument as items of
income or expense, or as changes in equity.
• ‘dividends’ on shares classified as liabilities are
recognised as expenses and affect profit or
loss.
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IAS 32
Financial Instruments: Presentation
15
Comparison to the IFRS for SMEs
• Section 22 Liabilities and Equity of the IFRS for
SMEs and IAS 32 share similar principles.
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IAS 32
Financial Instruments: Presentation
16
Judgements and estimates
• Some financial instruments may have the legal
form of equity but their substance is one of a
liability.
• Separating the liability and equity components
requires fair value estimates of the liability
component based on the contractual stream of
future cash flows discounted at the market rate
that would have been applied without the
conversion option.
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IFRS 2
Share-based Payment
17
Recognition
• The transaction is recognised when the entity
obtains the goods or services.
• Goods or services received are recognised as
assets or expenses as appropriate.
• The transaction is recognised as equity (if equitysettled) or as a liability (if cash-settled).
• If a payment is required, the payment amount is
based on the price of the entity’s shares (eg
share appreciation rights).
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International Financial Reporting Standards
Classifying liabilities
The views expressed in this presentation are those of the
presenter,
not necessarily those of the IASB or IFRS Foundation
© IFRS Foundation | 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Liability
19
Classification, recognition and
measurement
etc
Contingent
Provisions
Leases
Liabilities
Financial
Defined
Benefit
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Deferred
Tax
IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
20
Provisions
• A provision is a liability of uncertain timing or
amount (ie recognition is uncertain).
• A liability may be a legal obligation or a
constructive obligation.
• A constructive obligation arises from the entity’s
actions, through which it has indicated to others
that it will accept certain responsibilities, and as
a result has created an expectation that it will
discharge those responsibilities.
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IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
21
Examples—provisions
• Ex 1: Waste from A’s factory contaminated the
groundwater. Lawsuit: local community seek
compensation for damages to health from
contamination. A acknowledges wrongdoing.
Court is deciding extent of the compensation.
Lawyers expect ruling in +2 yrs &
compensation in the range of CU1,000,000 to
CU30,000,000.
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IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
• Ex 2: Waste from A’s factory contaminated the
groundwater. Required by law to restore the
environment. Estimates restoration cost
between 1,000,000 & 15,000,000. Unsure of
period to complete restoration.
• Ex 3: A manufacturer gives warranties to the
purchasers of its goods. Warranty = make
good, by repair or replacement, manufacturing
defects that become apparent within 3 years of
sale.
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22
IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
23
Examples—not provisions
• Ex 1: ‘provision’ for self-insurance
• Ex 2: Ski-resort operator operates in a very
cyclical business, with ‘good years’ and ‘bad
years’ depending primarily on the weather. To
reduce earnings volatility, it recognises
‘provisions’ in ‘good years’ to reverse in ‘bad
years’.
• Ex 3: ‘provision’ for depreciation
• Ex 4: ‘provision’ for doubtful debts
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IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
24
Example—constructive obligation
•
Waste from A’s factory contaminated the
groundwater. A is not required by law to
restore the contaminated environment & there
is no court case. However, in the reporting
period the entity publicly announced that it
would restore the contaminated environment
within the next 12 months.
© IFRS Foundation | 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
25
Contingent liabilities
• Contingent liabilities are:
• possible obligations whose existence will be
confirmed by uncertain future events that are not
wholly within the control of the entity.
• obligations that are not recognised because their
amount cannot be measured reliably or settlement
is not probable (eg litigation against the entity when
the occurrence of any wrongdoing by the entity is
uncertain and it is more likely than not that the entity
will successfully defend the case).
• Contingent liabilities are not recognised—definition
and recognition criteria are not met.
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IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
26
Example—contingent liability
• A community is seeking compensation from A
for damages to their health as a result of
contamination believed to be caused by A’s
plant.
It is doubtful whether A is the source of the
contamination because
– many entities operate in the same area
producing similar waste & it is unclear
which entity is the source of the leak
– A has taken precautions to avoid leaks
and is vigorously defending the case.
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IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
27
Example—contingent liability continued
• However, it is not certain that it did not caused
the leak and the true offender will only become
known after extensive testing has been
performed.
A’s legal counsel expects a court ruling in
approximately 2 years. If A loses the case,
compensation is likely to be in the range of
CU1,000,000 to CU30,000,000.
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IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
28
Example—contingent liability continued
It may be uncertain whether the entity has a
present obligation—this is the matter being
determined by the court.
– if taking account of all of the available
evidence, it is probable that the entity will
successfully defend the court case then the
entity has a possible obligation and hence a
contingent liability.
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IAS 37: Provisions, Contingent Liabilities
and Contingent Assets
29
Judgements and estimates
• In some cases judgement is used to determine
whether to recognise a provision (liability) or
merely to disclose a contingent liability.
• For example, when defending a court case in
which it is difficult to predict the outcome.
• In other cases judgement is used to determine
whether to disclose a contingent asset.
• For example, a plaintiff in a court case in
which it is difficult to predict the outcome.
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IFRS 9
Financial Instruments
30
Classification model: financial liabilities
All financial liabilities
Amortised
cost
Except:
Held for trading
Fair value
through
P&L
• Hybrid financial liabilities are bifurcated
• No reclassification permitted
2011
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October
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FVO for
mismatch,
managed on
FV basis and
hybrids
Own
credit in
OCI
IFRS 9
Financial Instruments
31
Judgements and estimates
• Classification of financial assets into IFRS 9
categories drives the subsequent measurement
and requires careful consideration of all
available evidence.
• Classification is made primarily based on an
entity’s business model
• Fair value measurement requires maximum
possible use of observable market data and the
minimum use of entity-specific factors.
• In the absence of a quoted active market, it will
be necessary to use valuation techniques.
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IAS 17
Leases
32
Classification of leases
• A finance lease transfers to the lessee substantially
all the risks and rewards incidental to ownership of
the leased asset.
• All other leases are operating leases.
• When a lease includes both land and buildings
elements, the classification of the land and building
elements are considered separately.
– in determining whether the land element is an
operating or finance lease, an important
consideration is that land normally has an indefinite
economic life.
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IAS 17
Leases
33
• Situations that individually or in
combination normally indicate a finance
lease:
– lease transfers ownership of the asset to
lessee
– from inception lessee reasonably certain to
exercise bargain purchase option
– lease term is for the major part of asset’s
economic life
– at inception PV of MLPs = substantially all
asset’s fair value
– specialised asset (only lessee can use
without major modifications)
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IAS 17
Leases
34
• Situations that individually or in
combination could indicate a finance lease
– lessee can cancel the lease but
compensates the lessor’s for associated
losses
– gains or losses from the fluctuation in the
residual value of the leased asset accrue to
the lessee
– lessee can continue the lease for a
secondary period at a rent that is
substantially lower than market rent
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Examples—lease classification
35
• Ex 1: On 1/1/20X1 enter into 5-yr
non-cancellable lease over a machine.
Machine’s cash cost = 100,000, economic
life = 10 yrs and residual value = 0.
Annual lease payments on 31/12: 4 ×
23,000 & 23,539 at end of yr 5 when
ownership transfers to the lessee.
The interest rate implicit in the lease is
5% p.a. which approximates lessee’s
incremental borrowing rate.
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Examples—lease classification
36
•
Ex 2: Same as Ex 1 except ownership of the
machine does not automatically transfer to the
lessee at the end of the lease. Instead, the
lessee has an option to acquire the machine
from the lessor on 1/1/20X6 for CU1.
•
Ex 3: Same as Ex 1 except economic life of
the machine is five years and ownership of the
machine does not transfer to the lessee at the
end of the lease.
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Examples—lease classification
•
Ex 4: Same as Ex 1 except ownership does
not transfers to lessee at the end of the lease.
Instead lessee has an option to continue the
lease asset for a further 5 years at a rent of
CU1 per year.
•
Ex 5: Same as Ex 1 except ownership
transfers to the lessee at the end of the lease
for a variable payment equal to the asset’s
then fair value (instead of 23,539).
© IFRS Foundation | 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
37
IAS 17
Leases
38
Operating leases
• The leased asset remains in the statement of
financial position of the lessor.
• Operating lease payments are usually
recognised in profit or loss on a straight-line
basis.
• From the perspective of the lessee, if payments
are subject to escalation, straight-line
recognition is profit or loss may give rise to a
liability on the statement of financial position
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IAS 17
Leases
39
Finance leases
• Finance leases are accounted for by lessees as
an asset purchased (other IFRSs then apply to
the asset) on credit (a liability).
• Initially, the liability is recognised at:
• the fair value of the leased property, or if lower
• The present value of the minimum lease
payments—the implicit interest rate is used as
the discount rate
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IAS 19
Employee Benefits
40
Employee benefits
• Employee benefits are all forms of consideration
paid for services of employees or for termination
of employment.
• IAS 19 separates employee benefits into 4
categories:
• short-term benefits
• post-employment benefits
• other long-term benefits
• termination benefits
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IAS 19
Employee Benefits
41
Short-term employee benefits
• Short-term employee benefits are expected to
be settled wholly before 12 months after the
period in which the employee rendered the
related service.
• recognise as an expense as the employee
provides the related service
• measure obligations at undiscounted amounts
(application of the cost constraint)
• no disclosures specified in IAS 19.
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IAS 19
Employee Benefits
•
42
Examples of Short-term employee benefits
include:
– wages, salaries & social security
contributions;
– S/T compensated absences (paid annual
leave & paid sick leave) for absences
expected to occur within 12 month
limitation;
– profit-sharing & bonuses payable within 12
month limitation; &
– non-monetary benefits (such as medical
care, housing, cars and free or subsidised
goods or services) for current employees.
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IAS 19
Employee Benefits
43
Post-employment benefits
• Post-employment benefits are payable after the
completion of employment.
• Two types:
• defined contribution plan, entity pays fixed
contributions to a separate entity (a fund) and
has no legal or constructive obligation to pay
further contributions if the fund cannot pay the
employee.
• all other post-employment plans are defined
benefit plans.
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IAS 19
Employee Benefits
44
Post-employment benefits—defined
contribution
• Employees (not the employer) are exposed to risks.
• Employer:
• recognises contributions payable as an expense as
the employee provides services in exchange for the
contributions.
• measures obligations for unpaid contributions at
undiscounted amounts (application of the cost
constraint).
• disclose amount recognised as an expense.
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IAS 19
Employee Benefits
45
Post-employment benefits—defined benefit
• Recognise the defined benefit liability as follows:
• use the projected unit credit method based on
actuarial assumptions to measured the obligation at
its present value; less
• the fair value of plan assets (if any).
• Recognise all changes in the defined benefit liability
(asset) when they occur:
• service costs and net interest in profit and loss
• remeasurements in other comprehensive income.
• Extensive disclosures specified.
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IAS 19
Employee Benefits
46
Other long-term benefits
• Other long-term benefits are all employee
benefits other than short-term employee
benefits, post-employment benefits and
termination benefits (eg long-service leave)
• Recognition and measurement is the same as
that for post-employment benefits: defined
benefit plans.
• No disclosures specified in IAS 19.
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IAS 19
Employee Benefits
47
Termination benefits
• Termination benefits arise only on termination,
rather than during employment.
• Principle—the event that gives rise to an obligation
is the termination of employment rather than
employee service
• Recognise expense and a liability at the earlier of:
• when the entity can no longer withdraw the offer of
those benefits
• when the entity recognises the related restructuring
provision in accordance with IAS 37.
• No disclosures specified in IAS 19.
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Questions or comments?
Expressions of individual
views
by members of the IASB and
its staff are encouraged. The
views expressed in this
presentation
are those of the presenter.
Official positions of the IASB
on accounting matters are
determined only after
extensive due process and
deliberation.
48
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49
The requirements are set out in International Financial
Reporting Standards (IFRSs), as issued by the IASB at
1 January 2012 with an effective date after 1 January
2012 but not the IFRSs they will replace.
The IFRS Foundation, the authors, the presenters and
the publishers do not accept responsibility for loss
caused to any person who acts or refrains from acting
in reliance on the material in this PowerPoint
presentation, whether such loss is caused by
negligence or otherwise.
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