COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic: Introduction to Liabilities

Learning Outcomes:
1. The student is expected to have a clear picture of the course perspective with proper awareness
of the coverage of the course.
2. Know the recognition criteria for liabilities and their essential characteristics.
3. Identify the characteristics of a financial liability.
4. Know the initial and subsequent measurements of financial and non-financial liabilities.
5. Know how to classify liabilities as current and noncurrent.

Core Value/Biblical Principles:

Proverbs 4:6-7
“Do not forsake wisdom, and she will protect you; love her, and she will watch over you. The beginning of wisdom
is this: Get wisdom, though it cost all you have, get understanding.”

Learning Activities and Resources:

Liabilities are a vital aspect of a company because they are used to finance operations and pay for large
expansions. They can also make transactions between businesses more efficient. For example, in most cases,
if a wine supplier sells a case of wine to a restaurant, it does not demand payment when it delivers the goods.
Rather, it invoices the restaurant for the purchase to streamline the drop-off and make paying easier for the
restaurant.

Introduction:
A liability is something a person or company owes, usually a sum of money. Liabilities are settled over time
through the transfer of economic benefits including money, goods, or services. Recorded on the right side of
the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues, bonds,
warranties, and accrued expenses.

Body:

Definition (Conceptual Framework, PAS 37)

“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.”

The essential characteristics of an accounting liability are:

a. The liability is the present obligation of a particular entity.
b. The liability arises from past event.
c. The settlement of the liability requires an outflow of resources.

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.
e.g. amounts payable for goods and services rendered

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.
e.g. warranty obligations
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.
e.g. “The acquisition of goods gives rise to accounts payable.”
Obligating Event

Outflow of future economic benefits

The settlement of a liability usually involves the entity transferring resources embodying economic
benefits in order to satisfy the claim of the other party.

Settlement of a present obligation may occur in a number of ways, for example, by:
 payment of cash;
 transfer of other assets;
 provision of services;
 replacement of that obligation with another obligation; or
 conversion of the obligation to equity.

Examples of Liabilities:
1. Accounts payable to suppliers for the purchase of goods or services.
2. Amounts withheld from employees or other parties for taxes and for contributions to the Philhealth,
HDMF, Social Security System or pension funds.
3. Accrual for wages, interest, royalties, taxes, product warranties and profit-sharing plans
4. Dividends (not stock dividends) declared but not paid
5. Deposits and advances from customers and officers
6. Debt obligations for borrowed funds – notes, mortgages, and bonds payable
7. Income tax payable
8. Unearned Revenue

INITIAL MEASUREMENT OF LIABILITIES

PFRS 9 requires an entity to recognize a financial liability in its statement of financial position when
it becomes party to the contractual provisions of the instrument. At initial recognition, an entity measures a
financial liability at its fair value minus, in the case of a financial liability not at fair value through profit or
loss, transaction costs that are directly attributable to the issue of the financial liability.
Transaction costs are included in the initial measurement of a liability measured at amortized cost.
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 Transaction costs do not

Transaction costs include
are directly attributable to the issue of a include
Fees and commissions paid to
financial liability. An incremental cost is one Debt premiums or discounts
agents, brokers, dealers, etc.
that would not have been incurred if the entity Levies by regulatory agencies
had not issued a financial liability. Financing costs
and security exchange
Internal administrative or
Transfer taxes and duties
Fair value of a financial liability (under holding costs
PFRS 13) is the amount that would be paid to transfer a liability in an orderly transaction between market
participants at the measurement date.
Conceptually, the fair value of the liability is equal to the present value of the 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.

SUBSEQUENT MEASUREMENT OF LIABILITIES

PFRS 9 provides that after initial recognition, an entity shall measure the financial liability:
1. At amortized cost, using the effective interest rate
2. At fair value through profit or loss

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 effective
interest method of any difference between the initial amount and the maturity amount.
Simply stated, the difference between the face amount and present value of the financial liability is
amortized through interest expense using the effective interest method.
The difference between the face amount and present value is either discount or premium on the issue
of financial liability.

Fair value option of measuring financial liability

PFRS 9, provides that at initial recognition an entity may irrevocably designate a financial liability at
fair value through profit or loss when doing so results in more relevant information.
In other words, under the fair value option, the financial liability is measured at fair value at every
year end and any change in far value is recognized in profit or loss. The interest expense is recognized using
nominal or stated rate.

CLASSIFICATION OF LIABILITIES

Under PAS 1 on presentation of financial statements, liabilities are classified into two, namely:
1. Current Liabilities
2. Noncurrent Liabilities

Current Liabilities – an entity shall classify a liability as current when it satisfies any of the following:
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 settled within 12 months after the reporting period.
d. The entity does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting period.

When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be
twelve months.
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 and recorded at face amount.

Noncurrent Liabilities - liabilities that are due after a year or more. Noncurrent liabilities 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

Long-term debt falling due within one year

 A liability which is due to be settled within twelve months after the reporting period is classified as
current, even if:
1. The original term was for a period longer than twelve months

2. 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 12
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 settlement of the
liability for at least 12 months after the reporting period, the obligation is classified as noncurrent.

Breach of Covenants
If certain conditions relating to the borrower’s financial situation are breached, the liability becomes
payable on demand.

Non-adjusting events
With respect to loans classified as current liabilities, the following events occurring between the end
of 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:
a. Refinancing on a long-term basis
b. Rectification of a breach of a long-term loan agreement
c. The granting by the lender of a grace period to rectify a breach of a long-term loan arrangement
ending at least 12 months after the long-term period.

Presentation of current liabilities

Under PAS 1, as a minimum, the face of the statement of financial position shall include the following line
items for current liabilities:
1. Trade and other payables
2. Current provisions
3. Short-term borrowing
4. Current portion of long-term debt
5. Current tax liability

Estimated Liabilities
Estimated liabilities are obligations which exist at the end of reporting period although their amount
is not definite. The date when the obligation is due is not also definite and the exact payee cannot be
identified or determined.
Estimated liabilities are either current or noncurrent in nature. Under PAS 37, an estimated liability
is considered as “provision” which is both probable and measurable.
e.g. liability for premium, award points, warranties, gift certificates and bonus.

Life Application:
Like businesses, an individual's or household's net worth is taken by balancing assets against liabilities. For
most households, liabilities will include taxes due, bills that must be paid, rent or mortgage payments, loan
interest and principal due, and so on. If you are pre-paid for performing work or a service, the work owed
may also be construed as a liability.
Summary:
 The IASB’s definition of a liability is: a present obligation of the enterprise arising from past events,
the settlement of which is expected to result in an outflow from the enterprise of resources
embodying economic benefits.
 Types of liabilities found in the balance sheet include current liabilities, such as payables and
deferred revenues, and long-term liabilities, such as bonds payable.
 Current liabilities are often loosely defined as liabilities that must be paid within one year. For firms
having operating cycles longer than one year, current liabilities are defined as those which must be
paid during that longer operating cycle.
 Long-term liabilities are reasonably expected not to be liquidated or paid off within a year. They
usually include issued long-term bonds, notes payables, long-term leases, pension obligations, and
long-term product warranties.
 Contingent liabilities can be current or long-term and usually deal with legal actions or litigation
claims against the entity or claims, such as penalties or fees, an organization encounters throughout
the course of business.

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Reference: Valix, C. T., Peralta, Jose F., Valix, C A M. (2014). Financial Accounting Volume 2
https://www.investopedia.com/terms/l/liability.asp
https://courses.lumenlearning.com/boundless-accounting/chapter/introduction-to-liabilities/