CHAPTER 1 – INTRODUCTION TO LIABILITIES

Topic Overview:
This module discusses liabilities, its characteristics, types and classification, and measurement
and recognition. This also explains the accounting procedures for the computation of bonus,
estimated liabilities, refundable deposits, premiums, cash rebate program, cash discount coupon,
cash loyalty program, warranties, provisions, and restructuring.

Learning Objectives:
After studying this module, the students should be able to:
1. Describe the essential characteristics of an accounting liability.
2. Enumerate the common types of liabilities.
3. Explain the measurement of current and noncurrent liabilities.
4. Determine the bonus for employees under the four variations.
5. Journalize and perform the accounting procedures for computation of bonus, estimated
liabilities, refundable deposits, premiums, cash rebate program, cash discount coupon, cash
loyalty program, warranties, provisions, and restructuring.

INTRODUCTION TO LIABILITIES
The Revised Conceptual Framework for Financial Reporting provides the following definition of
liabilities:
 Liabilities are present obligations of an entity to transfer an economic resource as a result
of past events.
Essential Characteristics of an Accounting Liability
A. The entity has a present obligation.
 An obligation is a duty or responsibility that an entity has no practical ability to avoid.
 The entity liable must be identified but it is not necessary that the payee to whom the
obligation is owed be identified.
 The present obligation may be legal or constructive.
 Obligations may be legally enforceable as a consequence of binding contract or statutory
requirement. (e.g. accounts 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 an equitable manner.
B. The obligation is to transfer an economic resource.
 The economic resource is the asset that represents a right with a potential to produce
economic benefits.
 Without payment of money, without transfer of noncash asset, without performance of
service, there is no accounting liability.
 When an entity declares cash dividend, there is an accounting liability since there is an
obligation to pay cash. But when an entity declares share dividend, there is no accounting
liability since the obligation is to issue its own shares. Share capital is an equity item,
hence, not considered as noncash asset.
C. The liability arises from past event.
 Liability is not recognized until it is incurred.
 The past event that leads to a legal or constructive obligation is known as the obligating
event.
 For example, the acquisition of goods on account gives rise to accounts payable. The
obligating event is the acquisition of goods.
Examples of Liabilities
The common types of liabilities include the following:
a) Accounts payable to suppliers for the purchase of goods
b) Amounts withheld from employees for taxes and for contributions to the Social Security
System
c) Accruals for salaries, interest, rent, taxes, product warranties and profit sharing bonus
d) Cash dividends declared but not paid
e) Deposits and advances from customers
f) Debt obligations for borrowed funds - notes, mortgages, and bonds payable
g) Income tax payable
h) Unearned revenue

Measurement of Current Liabilities

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 measured,
recorded and reported at their face amount since the difference between the face amount and the
present value is usually not material and therefore ignored.

Measurement of Noncurrent Liabilities

Noncurrent liabilities, for example, bonds payable and non-interest bearing note payable, are
initially measured at present value and subsequently measured at amortized cost.
If the long-term note payable is interest bearing, it is initially and subsequently measured at face
amount.

Current Liabilities
PAS 1, paragraph 69, 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.
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.
Trade payables and accruals for employee and other operating costs are part of the working
capital used in the entity's normal operating cycle, hence, classified as current even if settled
more than twelve months after the reporting period.
NOTE: When the entity's normal operating cycle is not clearly identifiable, its duration is
assumed to be twelve months.

Noncurrent Liabilities
All liabilities not classified as current 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 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:
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.
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 classified as noncurrent. Moreover, if the
entity has the discretion to refinance an obligation for atleast twelve months after the reporting
period under an existing loan facility, it is classified as noncurrent even if it would otherwise be
due within a shorter period.

Covenants
 are often attached to borrowing agreements which represent undertakings by the
borrower

Breach of Covenants
Under these covenants, if certain conditions relating to the borrowers financial situation are
breached, the liability becomes payable on demand.
PAS 1, paragraph 74, provides that such a liability is classified as current even if the lender has
agreed, after the reporting period and before the financial statements are authorized for issue, not
to demand payment as a consequence of the breach.
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.

Presentation of Current Liabilities

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
Estimated Liabilities
 are obligations which exist at the end of reporting period although their amount is not
definite
Deferred Revenue
 also known as unearned revenue
 income already received but not yet earned
 classified as current liability if realizable within one year
 classified as noncurrent liability if realizable in more than one year
Journal Entries
1. To record cash receipts
Cash xx
Unearned Service Revenue xx

2. To record the revenue recognized

Unearned Service Revenue xx
Service Contract Revenue xx
Journal Entries for Gift Certificates Payable
1. When the gift certificates are sold
Cash xx
Gift certificates payable xx

2. When the gift certificates are redeemed

Gift certificates payable xx
Sales xx

3. When the gift certificates are not redeemed

Gift certificates payable xx
Forfeited gift certificates xx

The Philippine Department of Trade and Industry ruled that gift certificates no longer have an
expiration period.

Bonus Computation
The main purpose of this scheme is to motivate officers and employees by directly relating their
well-being to the success of the entity.
The bonus computation usually has four variations:
1. Bonus as a certain percent of income before bonus and before tax
2. Bonus as a certain percent of income after bonus but before tax
3. Bonus as a certain percent of income after bonus and after tax
4. Bonus as a certain percent of income after tax but before bonus
Illustration:
Income before bonus and before tax P 4,400,000
Bonus 10%
Income tax rate 30%

Case 1 - Before bonus and before tax

Income before bonus and before tax P 4,400,000
Multiply by 10%
Bonus P 440,000

Case 2 - After bonus but before tax

B= Bonus Rate (Income before income and before tax minus bonus)
10% ( P 4,400,000 - B)
P 440,000 - 0.10B
B + 0.10B = P 440,000
1.10 B = P 440,000
B= P 440,000 / 1.10
B= P 400,000

Case 3 - After bonus and after tax

B= Bonus Rate ( Income before bonus and before tax - bonus - tax)
10% ( P 4,400,00 - B - T)
10% [ P 4,400,000 - B - 30% ( P 4,400,000 - B)]
10% ( P 4,400,000 - B - P 1,320,000 + 0.30B)
 P 440,000 - 0.10B - P 132,000 + 0.03B
B + 0.10B - 0.03B = P 440,000 - 132,000
1.07B = P 308,000
B= P 308,000 / 1.07B
B= P 287,850

Case 4 - After tax but before bonus

B= Bonus Rate ( Income before bonus and before tax - Income Tax)
10% [ P 4,400,000 - 30% ( P 4,400,000 - B)
10% ( P 4,400,000 - P 1,320,000 + 0.30B)
P 440,000 - 132,000 + 0.03B
B - 0.03B = P 440,000 - 132,000
0.97B = P 308,000
B= P 308,000 / 0.97
B= P 317, 526

Refundable Deposits
 consists of cash or property received from customers but which are refundable after
compliance with certain conditions
Illustration:
A deposit of P 10,000 is required from the customer for returnable containers. The containers
cost P 8,000.

The entry to record container’s deposit is:

Cash 10,000
Containers' Deposit 10,000

Containers' Deposit account is usually classified as current liability.

If the customer returns the containers, the deposit is simply refunded.
Containers' Deposit 10,000
Cash 10,000

However, if the customer fails to return the containers, the deposit is considered the sale price of
the containers.
The excess of the deposit for over the cost of the containers is considered as gain.

Premiums
 articles of value such as toys, dishes, silverware, and other goods given to customers as
result of past sales or sales promotion activities

The accounting procedures for the acquisition of premiums and recognition of the premium
liability are as follows:

1. When the premiums are purchased

Premiums xx
Cash xx

2. When the premiums are distributed to the customers

Premiums Expense xx
Premiums xx
3. At the end of the year, if the premiums are still outstanding
Premiums Expense xx
Estimated Liability xx

Illustration:
An entity manufactures a certain product and sells it at P300 per unit.
A soup bowl is offered to customers on the return of 5 wrappers plus a remittance of P10.
The bowl costs P50, and it is estimated that 60% of the wrappers will be redeemed.
The data for the first year concerning the premium plan are summarized below.

Sales, 10,000 units at P300 each P 3,000,000

Soup bowls purchased, 2,000 units at P50 each P 100,000
Wrappers redeemed 4,000

The entries that would be made in the first year are:

1. To record the sales
Cash 3,000,000
Sales 3,000,000

2. To record the purchase of the premiums

Premiums - soup bowls 100,000
Cash 100,000

3. To record the redemption of 4,000 wrappers

Cash [(4,000/5) × 10] 8,000
Premiums Expense [(4,000/5) × 40] 32,000
Premiums - soup bowls [(4,000/5) × 50] 40,000

4. To record the liability for the premiums at the end of the first year
Premium Expense 16,000
Estimated premium liability 16,000

Computation:
Wrappers to be redeemed (10,000 × 60%) 6,000
Less: Wrappers redeemed 4,000
Balance 2,000

Soup bowls to be distributed (2,000/5) 400

Multiply by: (50-10) 40
Estimated premium liability 16,000

OR
Soup bowls 2,000
Multiply by: 60%
Soup bowls expected to be distributed 1,200
Less: Soup bowls distributed (4,000/5) 800
Soup bowls to be distributed 400
Multiply by: (50-10) 40
Estimated premium liability 16,000

Financial Statement Classification

At the end of the year, the accounts related to the premium plan are classified as follows:
Current Asset
Premiums - soup bowls P60,000
Current Liability
 Estimated premium liability 16,000
Distribution Cost
Premium Expense 48,000

Cash Rebate Program

 a variation of premium offer
 cash register receipts, bar codes, rebate coupons, and other proof of purchase often can be
mailed to the manufacturer for cash rebate
Illustration:
An entity offered P500 cash rebate on a particular model of TV set. The customers must present
a rebate coupon enclosed in every package sold plus the official receipt.
Past experience indicates that 40% of the coupons will be redeemed.
During the current year, the entity sold 4,000 TV sets and total payments to customers amounted
to P450,000.
1. To record the cash rebate program
Rebate Expense 800,000
Estimated rebate liability 800,000
* 4,000 × 40% = 1,600 coupons; 1,600 × P500 = P800,000

2. To record the payments to customers

Estimated rebate liability 450,000
Cash 450,000

Cash Discount Coupon

 another variation of premium offer
 popular marketing tool for the purpose of stimulating sales

Illustration:
During the current year, an entity inserted in each package sold a coupon offering P300 off the
purchase price of a particular brand of product when the coupon is presented to retailers.

The retailers are reimbursed for the face amount of coupons plus 10% for handling. Previous
experience indicates that 30% of the coupons will be redeemed.

During the current year, the entity issued coupons with face amount of P5,000,000, and total
payments to retailers amounted to P1,100,000.

1. To recognize the cash discount coupon offer

Cash discount coupon expense 1,650,000
Estimated coupon liability 1,650,000
* P5,000,000 × 30% = 1,500,000 ; P1,500,000 × 110% = 1,650,000

2. To record payments to retailers

Estimated coupon liability 1,100,000
Cash 1,100,000

Customer Loyalty Program - IFRS 15

 generally designed to reward customers for past purchases and to provide them with
incentives to make further purchases
 If a customer buys goods or services, the entity grants the customer award credits often
described as "points".
 Customers may be required to accumulate a specified minimum number of award credit
or points before they can be redeemed.
Measurement
 separately component of the initial sale transaction
 accounted for as a " future delivery of goods or services
  The fair value of the consideration received with respect to the initial sale shall be
allocated between the award credits and the sale based on realtive stand-alone selling
price
 The stand-alone selling price is the price at which an entity would sell a promised good or
service separately to a customer.
Recognition
 The consideration allocated to the award credits is initially recognized as deferred
revenue and subsequently recognized as revenue when the award credits are
redeemed.
 The calculation of revenue to be recognized in any one period is made on a
"cumulative basis" in order to reflect the changes in estimate.
Illustration:
An entity, a grocery retailer, operates a customer loyalty program. The entity grants program
members loyalty points when they spend a specified amount on groceries. Program member can
redeem the points for further groceries. The points have no expiry date. The sales during 2020
amounted to P9,000,000 based on stand-alone selling price. During 2020, the customers earned
10,000 points but management expects 80% or 8,000 of these points will be redeemed. The
stand-alone selling price of each loyalty point is estimated at P100. On December 31,2020, 4,000
points have been redeemed in exchange for groceries. In 2021, the management revised
expectations and now expects 90% or 9,000 points will be redeemed altogether. During 2021, the
entity redeemed 4,100 points. In 2022, 900 points are further redeemed. Management continues
to expect that only 9,000 will be redeemed after 2022.

Allocation of transaction price

Product Sales P 9,000,000
Points, stand-alone selling price (10,000 × 100) 1,000,000
Total 10,000,000

Product Sales [(9M/10M) × 9M] P 8,100,000

Points [(1M/10M) × 9M] 900,000
Total transaction price 9,000,000

Journal Entries
The initial sale in 2020 is recorded as follows:
Cash 9,000,000
Sales 8,100,000
Unearned revenue – points 900,000

Redemption of 4,000 points in 2020

Unearned revenue – points 450,000
Sales 450,000
* 10,000 × 80% = 8,000 ; [(4,000/8,000) × 900,000] = 450,000

Redemption of 4,100 points in 2021

Unearned revenue – points 360,000
Sales 360,000
*10,000 × 90% = 9,000 ; [(8,100/9,000) × 900,000] = 810,000 ; 810,000 - 450,000 = 360,000

Redemption of 900 points in 2022

Unearned revenue – points 90,000
Sales 90,000
*[(9,000/9,000) × 900,000] = 900,000 ; 900,000 - 810,000 = 90,000
Third party Operates Loyalty Program
An entity, a retailer of electrical goods, participates in a customer loyalty program operated by an
airline. The entity grants program members one air travel point for every P1,000 spent on
electrical goods. Program members can redeem the points for travel with the airline subject to
availability. The entity pays the airline P60 for each point. During the current year, the entity
sold electrical goods for consideration totaling P4,500,000 based on stand-alone selling price and
granted 5,000 points with stand-alone selling price of P100 per point.

Product Sales P 4,500,000

Points, stand-alone selling price (5,000 × 100) 500,000
Total 5,000,000

Product Sales [(4.5M/5M) × 4.5M] P 4,050,000

Points [(0.5M/5M) × 4.5M] 450,000
Total transaction price 5,000,000

To record initial sale

Cash 5,000,000
Sales 4,050,000
Revenue from points 450,000

To record payment to airline

Loyalty Program Expense 300,000
Cash 300,000
*5,000×60= P300,000

Warranty
Home appliances like television sets, stereo sets, ratio sets, refrigerators and the like are often
sold under guarantee or warranty to provide free repair service or replacement during a specified
period if the products are defective. Such entity policy may involve significant costs on the part
of the entity if the products sold prove to be defective in the future within the specified period of
time.

Recognition of Warranty Provision

PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial
statements under the following conditions:
a. The entity has a present obligation, legal or constructive, as a result of a past event.
 The obligating event in this case is the sale of the product which gives rise to a
constructive obligation.
b. It is probable that an outflow of resources embodying economic benefits would be required to
settle the obligation.
 It is probable that there will be some claims against the warranty.
c. The amount of the obligation can be measured reliably.
 The amount recognized as the warranty provision should be the best estimate of the
expenditure to settle the present obligation.
 Where no reliable estimate can be made, no warranty liability is recognized.

Accounting for Warranty

There are two approaches in recording the warranty expense, namely:
 Accrual approach
 Expense as incurred approach
Accrual Approach

The accrual approach has the soundest theoretical support because it properly matches cost with
revenue. Following this approach, the estimated warranty cost is recorded as follows:
Warranty Expense xx
Estimated Warranty Liability xx

When actual warranty cost is subsequently incurred and paid, the entry is:
Estimated Warranty Liability xx
Cash xx

Any difference between estimate and actual cost is a change in estimate and therefore treated
currently or prospectively, if necessary.
Thus, if the actual cost exceeds the estimate, the difference is charged to warranty expense as
follows:
Warranty Expense xx
Estimated Warranty Liability xx

If the actual cost is less than the estimate, the difference is an adjustment to warranty expense as
follows:
Estimated Warranty Liability xx
Warranty Expense xx

Illustration:
An entity sells 1,000 units of television sets at P9,000 each for cash. Each television set is under
warranty for one year. The entity has estimated from past experience that warranty cost will
probably average P500 per unit and that only 60% of the units sold will be returned for repair.
The entity incurs P180,000 for repairs during the year.

Journal Entries
1. To record the sales:
Cash 9,000,000
Sales 9,000,000

2. To set up the estimated liability on the warranty:

Warranty Expense 300,000
Estimated Warranty Liability 300,000
* 1,000 × 60% = 600 ; 600 × P500 = P300,000

3. To record the payment of the actual cost:

Estimated Warranty Liability 180,000
Cash 180,000

The statement of financial position at the end of the year would report estimated warranty
liability of P120,000 as a current liability. The income statement for the year would show
warranty expense of P300,000. If the warranty runs over a period of more than one year, a
portion of the estimated warranty liability shall be reported as current liability and the remaining
portion as noncurrent liability. In other words, the warranty cost expected to be incurred within
one year is classified as current and the balance as noncurrent.
Expense as Incurred Approach
The "expense as incurred approach" is the approach of expensing warranty cost only when
actually incurred. This approach is justified on the basis of expediency when warranty cost is not
very substantial or when the warranty period is relatively short. The actual warranty cost of
P180,000 is simply recorded by debiting warranty expense and crediting cash.

Another Illustration
An entity sells refrigerators that carry a 2-year warranty against defects. The sales and warranty
repairs are made evenly throughout the year. Based on past experience, the entity projects an
estimated warranty cost as a percentage of sales as follows:
First year of warranty 4%
Second year of warranty 10%

2020 2021
Sales 5,000,000 6,000,000
Actual warranty repairs 140,000 300,000

Journal Entries
2020
1. To record the sale
Cash 6,000,000
Sales 6,000,000

2. To record the warranty expense

Warranty Expense 700,000
Estimated Warranty Liability 700,000
* 5,000,000 × 14% = 700,000
3. To record actual warranty repairs
Estimated Warranty Liability 140,000
Cash 140,000

2021
1. To record the sale
Cash 5,000,000
Sales 5,000,000

2. To record the warranty expense

Warranty Expense 840,000
Estimated Warranty Liability 840,000
* 6,000,000 × 14% = 840,000
3. To record actual warranty repairs
Estimated Warranty Liability 300,000
Cash 300,000

At this point, on December 31, 2021, the warranty liability is P1,100,000.

*700,000 + 840,000 = 1,540,000 ; [1,540,000 - (140,000 + 300,000)] = 1,100,000
Testing the Accuracy of Warranty Liability
On December 31, 2021, the estimated warranty liability account may be analyzed based on the
4% and 10% estimate to determine whether the actual warranty costs approximate the estimate.

Sales Made Evenly

To have an easier interpretation or understanding of sales accruing evenly during the year, it is
fair to assume that half of the sales were made on January 1 and the other half on July 1. Thus,
the first contract year under a 2-year warranty of the sales made on January 1, 2020 will be
within January 1, 2020 to December 31, 2020, and the second contract year will be within
January 1, 2021 to December 31, 2021. The first contract year under a 2-year warranty of the
sales made on July 1, 2020 will be within July 1, 2020 to June 30, 2021, and the second contract
year will be within July 1, 2021 to June 30, 2022.

Computations
If sales and warranty repairs are made evenly during the year, the warranty expense for 2020 and
2021, and the estimated warranty liability on December 31, 2021 are determined as follows:

Warranty expense related to 2020 sales

2020
First contract year of January 1, 2020 sales (2,500,000 × 4%) 100,000
First contract year of July 1, 2020 sales (2,500,000 × 4% × 6/12) 50,000

2021
First contract year of July 1, 2020 sales (2,500,000 × 4% × 6/12) 50,000
Second contract year of January 1, 2020 sales (2,500,000 × 10%) 250,000
Second contract year of July 1, 2020 sales (2,500,000 × 10% × 6/12) 125,000

2022
Second contract year of July 1, 2020 sales (2,500,000 × 10% × 6/12) 125,000
Total warranty expense for 2020 = 700,000

Warranty expense related to 2021 sales

2021
First contract year of January 1, 2021 sales (3,000,000 × 4%) 120,000
First contract year of July 1, 2021 sales (3,000,000 × 4% × 6/12) 60,000

2022
First contract year of July 1, 2021 sales (3,000,000 × 4% × 6/12) 60,000
Second contract year of January 1, 2021 sales (3,000,000 × 10%) 300,000
Second contract year of July 1, 2021 sales (3,000,000 × 10% × 6/12) 150,000

2023
Second contract year of July 1, 2021 sales (3,000,000 × 10% × 6/12) 150,000
Total warranty expense for 2021 = 840,000

The warranty costs after December 31, 2021 represent the estimated warranty liability on
December 31, 2021.
2020 sales still under warranty after December 31, 2021:
Second contract year of July 1, 2020 sales (2,500,000 × 10% × 6/12) 125,000

2021 sales still under warranty after December 31, 2021:

First contract year of July 1, 2021 sales (3,000,000 × 4% × 6/12) 60,000
Second contract year of January 1, 2021 sales (3,000,000 × 10%) 300,000
Second contract year of July 1, 2021 sales (3,000,000 × 10% × 6/12) 150,000
Second contract year of July 1, 2021 sales (3,000,000 × 10% × 6/12) 150,000

Estimated warranty liability - December 31, 2021 785,000

Estimated warranty liability per book 1,100,000
Decrease in warranty liability (315,000)

The decrease in warranty liability is an adjustment of the warranty expense of 2021.

Estimated Warranty Liability 315,000
Warranty Expense 315,000

Sale of Warranty
A warranty is sometimes sold separately from the product sold. When products are sold, the
customers are entitled to the usual manufacturer's warranty during a certain period. However, the
seller may offer an "extended warranty" on the product sold but with additional cost. In such a
case, the sale of the product with the usual warranty is recorded separately from the sale of the
extended warranty. The amount received from the sale of the extended warranty is recognized
initially as deferred revenue and subsequently amortized using straight line over the life of the
warranty contract. However, if costs are expected to be incurred in performing services under the
extended warranty contract, revenue is recognized in proportion to the costs to be incurred
annually.

Illustration
An entity sold a product for P3,000,000. The regular warranty period for the product is two
years. The entity sold an additional warranty of two years at a cost of P60,000. The sale is
recorded as follows:
Cash 3,060,000
Sales 3,000,000
Unearned Warranty Revenue 60,000

The extended warranty contract starts only after the expiration of the regular two-year warranty
period. If the costs are incurred evenly, the unearned warranty revenue is amortized at the end of
the third year as:

Unearned Warranty Revenue 30,000

Warranty Revenue 30,000
* 60,000/2 = P30,000

PROVISION
 What do you understand by the term "provision"?
 A provision is an existing liability of uncertain timing or uncertain amount.
The essence of a provision is that there is uncertainty about the timing or amount of
the future expenditure.
 Actually, a provision may be the equivalent of an estimated liability or a loss
contingency that is accrued because it is both probable and measurable.
 What are the conditions for the recognition of a provision as liability?
 PAS 37, paragraph 14, states that a provision shall be recognized as liability under the
following conditions:
1. The entity has a present obligation as a result of a past event.
2. It is probable that an outflow of economic benefits shall be required to settle the
obligation.
3. The amount of the obligation can be measured reliably.
 What is a present obligation?
 The present obligation may be legal or constructive.
It is fairly clear what a legal obligation is.
A legal obligation is an obligation arising from a contract, legislation or other
operation of law.
A constructive obligation is an obligation that is derived from an entity's actions
where:
1. The entity has indicated to other parties that it will accept certain responsibilities
by reason of an established pattern of past practice, published policy, or a
sufficiently specific current statement.
2. And as a result the entity has created a valid expectation on the part of other
parties that it will discharge those responsibilities.
 What is an "obligating event"?
 The past event that leads to a present obligation is called an obligating event.
An obligating event is an event that creates a legal or constructive obligation because
the entity has no realistic alternative but to settle the obligation created by the event
This is the case where:
a. The settlement of the obligation can be enforced by law.
b. 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.
 Explain briefly "probable outflow of economic benefits".
 For a provision to qualify for recognition, there must be not only a present obligation
but also a probable outflow of resources embodying economic benefits to settle the
obligation.
An outflow of resources is regarded as "probable" if the event is more likely than not
to occur.
This means that the probability that the event will occur is greater than the probability
that the event will not occur.
As a rule of thumb, '"probable" means more than 50% likely.
 Explain the measurement of a provision.
 The amount recognized as a provision should be the best estimate of the expenditure
required to settle the present obligation at the end of reporting period.
The best estimate is the amount that an entity would rationally pay to settle the
obligation at the reporting date or to transfer it to a third party at that time.
Where a single obligation is being measured, the individual most likely outcome may
be the best estimate.
However, even in such a case, the entity shall consider other possible outcomes.
Where there is a continuous range of possible outcomes and each point in that range
is as likely as any other, the midpoint of the range is used.
 Where the provision being measured involves a large population of items, the
obligation is estimated by "weighting" all possible outcomes by their associated
possibilities.
 Enumerate certain considerations in the measurement of provision.
 The risks and uncertainties that inevitably surround many events and circumstances
shall be taken into account in reaching the best estimate of a provision.
Where the effect of the time value of money is material, the amount of provision shall
be the present value of the expenditures required to settle the obligation.
Future events that affect the amount required to settle an obligation shall be reflected
in the amount of a provision.
Gains from expected disposal of assets shall not be taken into account in measuring a
provision.
Where the expenditure required to settle a provision is expected to be reimbursed by
another party, the reimbursement shall be recognized when it is virtually certain that
reimbursement will be received.
The reimbursement shall be treated as a separate asset and not "netted" against the
estimated liability for the provision. The amount shall not exceed the amount of the
provision.
However, in the income statement, the expense relating to the provision may be
presented net of the reimbursement.
Provisions shall be reviewed at each reporting date and adjusted to reflect the current
best estimate.
A provision shall be used only for expenditures for which the provision was
originally recognized.
Provision shall not be recognized for future operating losses.
If an entity has an onerous contract, the present obligation under the onerous contract
shall be recognized and measured as a provision.
 What is restructuring?
 PAS 37, paragraph 10, defines restructuring as a "program that is planned and
controlled by management and materially changes either the scope of a business of an
entity or the manner in which that business is conducted".
Examples of events that may qualify as restructuring include:
a. Sale or termination of a line of business
b. Closure of business location in a region or relocation of business activities from one
location to another
c. Change in management structure, such as elimination of a layer of management
d. Fundamental reorganization of an entity that has a material and significant impact on
the operations
 What is the amount of the restructuring provision?
 A restructuring provision shall include only direct expenditures arising from the
restructuring.
The expenditures are necessarily entailed by the restructuring and not associated with
the ongoing activities of the entity.
For example, salaries and benefits of employees to be incurred after operations cease
and that are associated with the closure of the operations shall be included in the
amount of the restructuring provision.
PAS 37, paragraph 81, specifically excludes the following expenditures from the
restructuring provision:
a. Cost of retraining or relocating continuing staff
 b. Marketing or advertising program to promote the new entity image
c. Investment in new system and distribution network

Illustration
During 2018, Odyssey Company is the defendant in a patent infringement lawsuit. The entity's
lawyers believe that there is a 30% chance that the court will dismiss the case and the entity will
incur no outflow of economic benefits.

However, if the court rules in favor of the claimant, the lawyers believe that there is a 20%
chance that the entity will be required to pay damages of P200,000 and an 80% chance that the
entity will be required to pay damages of P 100,000. Other outcomes are unlikely.
The court is expected to rule in late December 2019. There is no indication that the claimant will
settle out of court.

A 7% risk adjustment factor to the probability-weighted expected cash flows is considered

appropriate to reflect the uncertainties in the cash flow estimates.
An appropriate discount rate is 5% per year. The present value of 1 at 5% for one period is 0.95.
What is the measurement of the provision for lawsuit?

Solution:

Weighted Probabilities
20% × 200,000 × 70% P 28,000
80% × 100,000 × 70% 56,000
Weighted Cash flows 84,000
Multiply by risk adjustment factor (100% + 7%) 1.07
Adjusted cash flows 89,880
Multiply by PV of 1 at 5% for one period .95
Present value of cash flows P 85,386

Contingent Liability and Contingent Asset

 What is contingent liability?
 PAS 37, paragraph 10, defines a contingent liability in two ways:
a. A contingent liability is a possible obligation that arises from past event and
whose existence will be confirmed only by the occurrence or nonoccurrence of
one or more uncertain future events not wholly within the entity's control.
b. A contingent liability is a present obligation that arises from past event but is not
recognized because it is not probable that a transfer of economic benefits will be
required to settle the obligation or the amount of the obligation cannot be
measured reliably.
 Explain the three ranges of outcome of future uncertain events.
 The uncertainty relating to future events can be expressed by a range of outcome.
The range of outcome may be described as follows:
a. Probable - The future event is likely to occur.
As a rule of thumb, probable means more than 50% likely.
b. Reasonably possible - The future event is less likely to occur.
c. Remote — The future event is least likely to occur or the chance of the future event
occurring is very slight.
 What is the treatment of a contingent liability?
  A contingent liability shall not be recognized in the financial statements but shall be
disclosed only.
If the contingent liability is remote, no disclosure is necessary.
 What is a contingent asset?
 PAS 37, paragraph 10, defines a contingent asset as a possible asset that arises from
past event and whose existence will be confirmed by the occurrence or nonoccurrence
of one or more uncertain future events not wholly within the entity's control.
A contingent asset shall not be recognized because this may result to recognition of
income that may never be realized.
However, when the realization of income is virtually certain, the related asset is no
longer contingent asset and its recognition is appropriate.
A contingent asset is only disclosed when it is probable.
If a contingent asset is only possible or remote, no disclosure is required.
Illustration
In May 2018, Caso Company filed suit against Wayne Company seeking P1,900,000 damages
for patent infringement. A court verdict in November 2018 awarded Caso P1,500,000 in
damages, but Wayne's appeal is not expected to be decided before 2019.
Caso's counsel believed it is probable that Caso will be successful against Wayne for an
estimated amount in the range between P800,000 and P,100,000, with P1,000,000 considered the
most likely amount.
What amount should Caso record as income from the lawsuit for the year ended December 31,
2018?
Answer:
P0. A contingent asset and the related contingent gain are disclosed only where the inflow of
economic benefits is probable.

References:

Valix, et. al. (2019). Intermediate Accounting Volume 2, Manila, Philippines

Asuncion, et. al. (2018). Applied Auditing Book 2 of 2, Baguio City: Real Excellence Publishing
Valix, et. al. (2016). Financial Accounting Volume 2, Manila Philippines
Assessment

Exercise 1. Determine the bonus for employees under these four variations.

1. Bonus as a certain percent of income before bonus and before tax

2. Bonus as a certain percent of income after bonus but before tax
3. Bonus as a certain percent of income after bonus and after tax
4. Bonus as a certain percent of income after tax but before bonus

Income before bonus and before tax P 8,800,000

Bonus 10%
Income tax rate 30%

Exercise 2. Provide the journal entries for gift certificates payable.

Gift certificates to be redeemed P50,000

Gift certificates redeemed P20,000

Exercise 3. Record the following transactions regarding container’s deposit:

 A deposit of P 25,000 is required from the customer for returnable containers. The
containers cost P 20,000.
 The customer returned the containers.

Exercise 4.
An entity manufactures a certain product and sells it at P600 per unit. A vase is offered to
customers on the return of 10 wrappers plus a remittance of P20. The vase costs P100, and it is
estimated that 60% of the wrappers will be redeemed. The data for the first year concerning the
premium plan are summarized below.

Sales, 10,000 units at P600 each P 6,000,000

Vases purchased, 2,000 units at P100 each P 200,000
Wrappers redeemed 4,000

Exercise 5.
During 2018, Madali Lang To Company is the defendant in a patent infringement lawsuit. The
entity's lawyers believe that there is a 30% chance that the court will dismiss the case and the
entity will incur no outflow of economic benefits.

However, if the court rules in favor of the claimant, the lawyers believe that there is a 40%
chance that the entity will be required to pay damages of P500,000 and an 60% chance that the
entity will be required to pay damages of P 300,000. Other outcomes are unlikely.

The court is expected to rule in late December 2019. There is no indication that the claimant will
settle out of court.

A 7% risk adjustment factor to the probability-weighted expected cash flows is considered

appropriate to reflect the uncertainties in the cash flow estimates.
An appropriate discount rate is 5% per year. The present value of 1 at 5% for one period is 0.95.

What is the measurement of the provision for lawsuit? Provide your solution.