Chapter 1 Questions 1. Define liabilities Answer:
The Conceptual Framework for Financial Reporting provides the following definition of 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.” 2. What are the essential characteristics of an accounting liability? Answer:
a) The liability is the present obligation of a particular entity b) The liability arises from a past event - which simply means that liability is not recognized until it is incurred. c)
The settlement of the liability requires an outflow of resources embodying economic benefits - this is the very heart of the definition of an accounting liability. The obligation must be to pay cash, transfer noncash asset or provide service at some future time.
3. Explain a present obligation Answer:
The present obligation may be a legal obligation or a constructive obligation. The obligation is the duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of binding contract or statutory requirement. This is normally the case, for example, with amounts 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 adequate manner. For example, an entity decides as a matter of policy to rectify faults in its product even when these become apparent after the warranty period has expired. 4. Explain a past event that leads to a present obligation Answer:
The past event that leads to legal or constructive obligation is known as the obligating event. The
obligating event creates a present obligation because t he 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. 5. Explain outflow of future economic benefits to settle an obligation Answer:
Without payment of money, without transfer of noncash asset, without performance of service, there is no accounting liability. But when the entity declares stock dividend, there is no accounting liability. The obligation is to issue the entity’s own shares. The issuance of the entity’s shares is not a transfer of noncash asset because the share capital is an equity item. Thus, stock dividend payable is classified as part of equity rather than an accounting liability. 6. Give specific examples of liabilities Answer:
a) Accounts payable b) Amounts withheld from employees or other parties for t axes and contribution to the SSS or to pension funds c)
Accruals for wages, interest, royalties, taxes, product, warranties and profit sharing plans
d) Dividends (not stock dividend) declared but not yet paid e) Deposits and advances from customers and officers f)
Debts obligations for borrowed funds
g) Income tax payable h) Unearned revenue 7. Explain the initial measurement of liabilities Answer:
PFRS 9, paragraph 5.1.1, provides that an entity shall measure initially a financial liability at its fair value minus, in the case of financial liability not designated at fair value through profit or loss, transaction costs that are directly attributable t o the issue of the financial liability. The transaction costs are included in the initial measurement of the financial liability measured at amortized cost. The 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 the financial liability.
An incremental cost is the one that would not have been incurred if the entity had not issued the financial liability. Transaction costs include: a) Fees and commissions paid to agents, advisers, brokers and dealer s b) Levies by regulatory agencies and security ex changes c)
Transfer taxes and duties
Transaction costs do not include: a) Debt premiums or discounts b) Financing costs c)
Internal administrative or holding costs
8. What is the fair value of a financial liability? Answer:
Fair value is the amount for which a liability is settled between knowledgeable and willing parties in an arm’s length transaction. In other words, fair value of the liability is equal to the present value of t he future cash payment to settle the obligation. The term “present value” is the discounted amount of the future cash outflow in setting an obligation using the market rate of interest. 9. Explain the subsequent measurement of liabilities Answer:
PFRS 9, paragraph 5.3.1, provides that after initial recognition, an entity shall measure a financial liability: a) At amortized cost, using the effective interest method b) At fair value through profit or loss 10. What is the meaning of amortized cost of a financial liability? Answer:
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. Simply stated, the difference between the face amount and present value of the liability is amortized through interest expense using the effect ive interest method.
Actually, the difference between the face amount and present value is either discount or premium on the issue of financial liability. 11. Explain the measurement of noncurrent liabilities Answer:
Noncurrent liabilities are initially measured at present value and subsequently measured at amortized cost. However, in the case of the interest-bearing long-term note, it is initially and subsequently measured at face amount because in this case, the face amount is equal to the present value of the note payable. 12. Explain the measurement of current liabilities Answer:
Conceptually, all liabilities are measured initially at present value and subsequently 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. 13. What is the fair value option of measuring a financial liability? Answer:
PFRS 9, paragraph 4.2.2, provides that at initial recognition an entity may irrevocably designate financial liability at fair value through profit or loss when doing so results in more relevant information. Under the fair value option, the financial liability is measured at fair value at every year-end and any change in fair value is recognized in profit o r loss. The amortization rules for discount or premium no longer apply. Accordingly, under the fair value option, the interest expense is recognized using the nominal or stated rate, 14. What are the classifications of liabilities in the statement of financial position? Answer:
a) Current liabilities b) Noncurrent liabilities
15. Define current liabilities Answer:
PAS 1, paragraph 69, provides that an entity shall classify liability as 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 settled 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. Operating items like “trade payables”, “accruals for employee” and other operating costs are classified as current liabilities even if they are settled more than twelve months after the reporting period because they are part of the working capital used in the entity’s normal operating cycle. When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be twelve months. Other current liabilities like financial liabilities held for trading, bank overdraft, dividends payable, income taxes, other nontrade payables and curre nt portion of noncurrent financial liabilities, are not settled as part of the normal operating cycle but are due for se ttlement within twelve months after the reporting period or held primarily for the purpose of trading. Financial liabilities held for trading are financial liabilities that are incurred with an intention to repurchase them in the near term. Example is a quoted debt instrument that t he issuer may buy back in the near term depending on changes in fair value. 16. Define noncurrent liabilities Answer:
It is a residual definition of current liabilities. All liabilities not classified as current liabilities are classified as noncurrent liabilities. 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 17. Explain a treatment of a long-term debt falling due within one year Answer:
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 befor e 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 due within a shorter period. The reason for this treatment is that such obligation is considered to form a part of the entity's longterm 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 per iod. Note that the refinancing or rolling over m ust be at the discretion of the entity. Otherwise, if the refinancing or rollover is not at the discretion of t he entity, the obligation is classified as current liability.
18. What are covenants attached to borrowing agreements? Answer:
Covenants are often attached to borrowing agreements which represent undertakings by the borrower. These covenants are actually restrictions on the borrower as to undertaking further borrowings, paying dividends, maintaining specified level of working capital and so forth. 19. Explain the treatment of a liability if the covenants are breached or violated Answer:
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 if the lender has agreed, after the reporting period and before the statements is authorized for issue, not to demand payment as a consequence of the breach. This liability is classified as current because at the e nd of the reporting period, the entity does not have an unconditional right to defer its settlement for at least twelve months after these date. However, the liability is classified as noncurrent if the lender has agreed on or before the end of the reporting period to provide a grace period ending at least twelve months after 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.
20. How are current liabilities presented in the statement of financial position? Answer:
Under Paragraph 54 of PAS 1, as a minimum, the face of the statement of financial position shall include the following line items for 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, accr ued interest on note payable, dividends payable and accrued expenses. No objection can be raised if the trade accounts and notes payable are separately presented. An entity shall present additional line items on the face of the statement of financial position when such presentation is relevant to an understanding of the entity's financial position. An entity makes the judgment about w hether to present additional items separately on the basis of an assessment of the amount, nature and timing of t he liabilities. 21. What are estimated liabilities? Answer: 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 in some instances , t he exact payee cannot be identified or determined. But inspite of these circumstances, the existence of the estimated liabilities is valid and unquestioned. 22. Explain the classification of estimated l iabilities in the statement of financial position Answer:
Estimated liabilities are either current or noncurrent in nature. Examples include estimated liability for premium, award points, warranties, gift certificates and bonus. Under PAS 37, an estimated liability is considered as a "provision" which is both probable and measurable.
