Current Liabilities 1 Chapter 1 Current Liabilities Related standards: PAS 1: Presentation of Financial Statements PAS 32: Financial Instruments: Presentation PERS 9: Financial Instruments Learning Objectives 1, State the recognition criteria for liabilities. 2. Identify the characteristics of a financial liability. 3. Classify liabilities as current and noncurrent. 4, State the initial and subsequent measurements of financial and non-financial liabilities. re Liability Liability’ is “a present obligation of the entity to transfer an economic resource as a result of past events.” (Conceptual Framework 4.26) The definition of liability has the following three aspects: a. Obligation © b. Transfer of an economic resource -,. c. Present obligation as a result of past events Obligation * An obligation is “a duty or responsibility that an entity has no practical ability to avoid.” (Conceptual Framework 4.29) An obligation is either: ¢ a. -Legal_obligation - an obligation~that. results from a™ contract, ) so eee or other ‘eration of | of Jaw; ae § actions e. st practice or publi hi d licies; that (entity’ tions (e.g., past practic published policies)2 Chapter 1 Si ee eee et hapten create a valid expectation on others that the entity will accept and discharge certain responsibilities. An obligation is always owed to another party. However, it is mot necessary that the identity of that party is known, for example, an obligation for environmental damages may be owed to the society at large. One party's obligation normally corresponds to another party’s right. For example, a buyer’s obligation to pay an accounts payable of 100 normally corresponds to the seller's right to collect an accounts receivable of #100. However, this accounting symmetry is not maintained at all times because the Standards sometimes contain different recognition and measurement requirements for the liability of one party and the corresponding asset of the other party. For example, direct origination costs result to different measurements of the lender's loan receivable and the borrower's loan payable. Similarly, a seller may be required to recognize a warranty obligation but the buyer would not recognize a corresponding asset for that warranty. ‘There can be instances where the existence of an obligation is uncertain. Until that uncertainty is resolved (for example, by a court ruling), it is uncertain whether a liability exists. Transfer of an economic resource The liability is the obligation that has the potential to require the transfer of an economic resource to another party and not the future economic benefits that the obligation may cause to be transferred. Thus, the obligation’s potential to cause a transfer of, economic benefits need not be certain, or even likely, for example, the transfer may be required only if a specified uncertain future ‘event occurs. What is important is that the obligation already exists and that, in at least one circumstance, it would require the entity to transfer an economic resource. Consequently, a liability can exist even if the probability of a transfer of an economic resource is low, although that low Probability affects decisions on whether the liability is to beCurrent Liabilities 3 recognized, how it is measured, what information is to be provided about the liability, and how that, information is provided. (Conceptual Framework 4.37 & 4.38) An obligation to transfer an economic resource may be an obligation to: . a. pay cash, deliver. goods, or render services; _b. exchange assets with another party on unfavorable terms; c, “transfer assets if a specified uncertain future event occurs; or d. issue a financial instrument that obliges the entity to transfer an economic resource. Present obligation as a result of past events The obligation must be a present obligation that exists'as a’ result of past events. A present obligation exists as a result of past events ift a. the entity has already obtained economic benefits or taken an action; and b, as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. (Conceptual Framework 4.43) Exampl pri cys os siti Entity A intends to acquire goods inthe future, Analysis: Entity A has no present obligation. A present obligation arises only when Entity A: a, .has already purchased and received the goods; and b...as a.consequence, Entity A will have to pay for the purchase price. Entity B operates a nuclear power plant. In the current year, a new, law was enacted penalizing the improper disposal of toxic waste.4 Chapter 1 Analysis: The enactment of legislation is not in itself sufficient fo result in an entity’s present obligation, except when the entity: a. has already taken an action contrary to the provisions of that law; and b, asa consequence, the entity will have to pay for a penalty. Accordingly: - Entity B has no present obligation if its existing method of waste disposal does not violate the new law. Similarly, Entity B has no present obligation if it can avoid penalty oy changing its future method of waste disposal. - On the other hand, Entity B has a present obligation if its previous waste disposal has already caused damages, and as a consequence, Entity B has to pay for those damages. Entity C enters into an irrevocable commitment ‘with another to acquire goods in the future, on credit. Pl ied Analysis: A non-cancellable future commitment gives rise to a present obligation only when it becomes onerous (i.e., burdensome), for example, if the goods become obsolete before the delivery but Entity C cannot cancel the contract without paying a substantial penalty. Unless it becomes burdensome, no present obligation ~ normally arises from a future commitment. ‘Although not stated in the sales contract, Entity D has a publicly- | known policy of providing free repair services for the goods it sells. Entity D has consistently honored this implied policy in the past. z Analysis: Entity D has a present constructive obligation to provide free * repair services for the goods it has already sold because:Current Liabilities 5 a. Entity D has already taken an action by creating valid expectations on the customers that it will provide free repair services; and . b. as a consequence, Entity D will have to provide those free services. _ | Entity E obtained a loan from a bank. Repayment of the loan is due in 10-years’ time. Analysis: Entity E has a present obligation because it has already received the loan proceeds, and as a consequence, has to make the repayment, even though the bank cannot enforce the repayment until a future date. Entity F has caused environmental damages. Although, no law exists penalizing such act, Entity F believes it has an obligation to rectify the damages. However, the identity of the party to whom the obligation is owed cannot be specifically identified, Analysis: Entity F has a present obligation because it has already caused the damages, and as a consequence, has to rectify the damages, even if the identity of the party to whom the obligation is owed is not specifically known. Entity G employed Mr. Juan. Analysis: Entity G’has no present obligation to pay ‘salary until after Mr. Juan has rendered service. Before then, the contract is executory - Entity G’has a combined right and obligation to exchange future salary for Mr. Juan's future service.6 Chapter 1 Executory contracts Ja An executory contract “is a contract that is ally) unperformed - neither party has fulfilled any of its obligations, or both parties have ally fulfilled their obligations to an equal extent.” eee An executory contract establishes a combined right and obligation to exchange economic resources, which are interdependent and inseparable. Thus, the two constitute a single asset or liability. The entity has an asset if the terms of the contract are favorable; a liability if the terms are unfavourable. However, whether such an asset or liability is included in the financial statements depends on the recognition criteria and the selected measurement basis, including any assessment of whether the contract is onerous. The contract ceases to_be executory when one party performs i igation. If the enti rforms first, the entity's combined right and obligation changes to an asset, If the other party performs first, the entity’s combined right and obligation changes toa liability, Continuing the previous example: - Entity G neither recognizes an asset nor a liability upon entering the employment contract with Mr. Juan because, at that point, the contract is executory. - _ IfMr. Juan renders service, the contract ceases to be executory, and Entity G’s combined right and obligation changes to a liability — an obligation to pay Mr. Juan's salary (e.g., salaries payable). - If Entity G pays Mr. Juan’s salary in advance, Entity. G’s combined right and obligation changes to an asset — a right to receive the service or a right to be reimbursed if the service is not received (e.g., advances to employees).Current Liabilities 7 Recognition criteria . An item is recognized if: a. itmeets the definition of a liability; and b. recognizing it would provide useful information, i.e., rele and faithfully represented information. Both the criteria above must be met before an item is recognized. Accordingly, items that meet the definition of a liability but do not provide useful information are not recognized, and vice versa. However, even if a liability is not’ recognized, information about it may still need to be disclosed in the notes. In such cases, the item is referred to as unrecognized liability. Relevance Recognition may not provide relevant information if, for example: a. itis uncertain whether a liability exists; or b. aliability exists, but the probability of an outflow of economic benefits is low. (Conceptual Framework 5.12) “ Existence uncertainty or low probability of an outflow of economic benefits may result in, but does not automatically lead to, the non-recognition of a liability. Other factors should be considered. Faithful representation A liability. must be measured for it to be recognized. Often, measurement requires estimation and thus subject to measurement uncertainty. The use of reasonable estimates is an essential part of financial reporting and does not’ necessarily undermine the usefulness of information. Even a high level of measurement uncertainty does not necessarily preclude an estimate from providing useful information if the estimate is clearly and: accurately described and explained. However, an exceptionally high measurement uncertainty can affect the faithful representation of a liability.8 Chapter 1 Financial and Non-financial liabilities Financial liability - is any liability that is: a. A contractual obligation to deliver cash or’ another financial asset to another entity; b. A contractual _obligation to exchange. financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or ¢. A contract that will or may be settled in the entity’s own equity instruments and is not classified as the entity’s own equity instrument. ‘ Non-financial liability — is a liability other than a financial liability, Examples of financial liabilities a Payables 6 such as accounts, Rates, loans, bonds and accrued Held for trading liabilities and derivative liabilities Redeemable preference shares issued Security deposits and other ‘returnal EARS wr The following 3 ‘ré hot financial al liabilities: a. Unearned revenues and warranty-obligations that are to be settled through future—delivery of _goods or provision of services. ‘ b. . Taxes, SSS, Philhealth, and Pag-IBIG payables ¢. Constructive obligations fcoaes deposits Items (b) and (c) are not financial liabilities because they do not arise from contracts: Commodity ec contracts that cannot be settled net in cash or other financial instrument but only through commodity exchange (e.g, coffee beans, gold bullion, oil, and the'like) are not financial instruments. P Commodity contracts that can be settled net in cash or ‘other financial instrument are financial instruments. Such aCurrent Liabilities 9 commodity contract is a financial asset to the party to. whom conditions are potentially favorable, and a financial liability to the party to whom conditions are potentially unfavorable. Presentation of financial instruments The issuer classifies a financial instrument, or its component parts, as a financial asset, a financial liability or an equity instrument in accordance with the substance of the contract (rather than its legal form) and the definitions of a financial asset, a financial liability and an equity instrument. > Equity instrument — is “any contract that evidences-a residual interest in the assets of an entity after deducting all of its liabilities.” (PAS 32.11) This definition reflects the basic accounting equation “Assets — Liabilities = Equity.” When determining whether a financial instrument is a financial liability or an equity instrument, the overriding consideration is whether the instrument meets the definition of a financial liability. Financial liability Equity instrument > Theentity has a contractual |'> The entity has.no obligation obligation to pay cash or to pay cash or another another financial asset or to financial asset or to exchange financial exchange financial instruments under instruments under potentially unfavorable potentially unfavorable condition. 2 condition. ” A contract is not an equity instrument merely because it is to be settled in the entity’s own equity instruments. The following, guidance applies when a contract requires settlement in the entity’s own equity instruments:10 > The contract requires the delivery* of a) ise umber of the entity’s own equity instruments in exchange for a fixed amount of cash or another financial asset; or b) a fixed number of the entity’s own equity instruments in exchange for a variable amount of cash or another financial asset. > . Examples: a) Variable number for a fixed amount: acontract to deliver as many shares as are equal to 100,000. b) Fixed number for a variable amount: + ‘acontract to deliver 1,000 shares in exchange for an amount of cash equal to the value of 100 grams of gold. Chapter 1 Equity instrument > The contract requires the delivery (receipt) of a fixed numiber of the entity's own equity instruments in exchange for a fixed amount of cash or another financial — asset. Example: a share option that gives the holder the right to buy 1,000 shares of the issuer for P10 per share. A contract to receive (rather than to deliver) is a financial asset. & Notes: Financial asset/Financial ante > Variable number for a fixed amount. Fixed number for a variable amount. > Equity instrument > Fixed number for a fixed amount.Current Liabilities * Cee ia a ee ieee An essential feature of an equity instrument is the absence of a contractual obligation to pay cash or another financial asset. This is true even if the holder of the instrument is entitled to pro rata share in dividends or of the net assets of the entity in case of liquidation. Legal form is also irrelevant when determining if a financial instrument is a financial liability or an equity instrument. Some instruments are in the form of shares of stocks but the issuer classifies them as financial liabilities if they meet the definition of a financial liability. [ Redeemable preference shares Callable preference shares - are preferred stocks which | - . are preferred stocks which the holder has the right to the issuer has the right to call redeem at a set date. ata set date. - are classified as financial - are classified as equity liability because when the instrument because the right holder exercises its right to to call is at the discretion of redeem, the issuer is the issuer and therefore has mandatorily obligated to pay no obligation to pay unless it for the redemption price. chooses to call on the shares. IFRIC 2 Members’ Shares in Co-operative Entities and Similar Instruments addresses the classification of members’ shares in cooperatives. IFRIC 2 uses the same principles as those of PAS 32. Members’ shares in cooperative entities and similar instruments are equity if: a. The entity has an unconditional right to refuse redemption of the members’ shares, or b. Redemption is unconditionally prohibited by law or relevant * regulation.2. © Mlustration: Financial liabilities The records of an entity show the following: Chapter 1 Accounts payable 2,000 | SSS contributions payable 6,009 Utilities payable 7,000 | Cash dividends payable | 4,009 Accrued interest expense! 6,000 | Property dividends payable | _7,009 ‘Advances from customers | 1,000 | Share dividends payable | _3,000 Uneamed rent |_ 9,000 | Lease liability [35,000 Warranty obligations 5,000 | Bonds payable | 120,000 Income taxes payable 2,000 | Discount on bonds payable (15,000) Preference shares issued | 10,000 | Security deposit 2,000 Constructive obligation | 11,000 | Redeemable preferences shares issued 14,000 Obligation to deliver a Unearned interest on variable number of own receivables 3,000 shares worth a fixed | amount of cash 10,000 sal ‘Requirement: Determine the financial liabilities to be disclosed in the notes. Solution: Accounts payable Utilities payable Accrued interest expense (Interest payable) Obligation to deliver a variable number of own shares worth a fixed amount of cash Cash dividends payable Finance lease liability Bonds payable Discount on bonds payable Security deposit Redeemable preference shares issued Total financial liabilities 2,000 7,000 6,000 10,000 4,000 35,000 * 120,000 (15,000) 2,000 14,000 185,000 —Current Liabilities 13 Recognition of financial lial A financial liability is recognized only when the entity becomes a party to the contractual provisions of the instrument. Classification of Financial Liabilities All financial liabilities are classified as subsequently measured at amortized cost, except for the following: a. Finandial liabilities at fair value through profit or loss (FVPL) and derivative liabilities - subsequently measured at fair value (e.g., designated or held for trading). b.. Finandial liabilities that arise when a transfer of a financial asset does not qualify for derecognition - subsequently measured on a basis that reflects the rights and obligations " that the entity has retained. c, Financial guarantee contracts and Commitments to provide a loan at a below-market interest rate ~ subsequently measured at the higher of: i. the amount of the loss allowance (12-month expected credit losses); and ii, the amount initially recognized less, when appropriate, the cumulative amount of income recognized in accordance with the principles of PFRS 15. d, Contingent consideration recognized by an acquirer in a "business combination — subsequently measured at fair value through profit or loss. Reclassification of financial liabilities after _ initial recognition is prohibited. Measurement of Financial Liabilities _ Initial measurement Financial liabilities. re, zinitially measured at fair 2 value minus’ transaction costs, jt Financial liabilities classified as .EVPL are initially measured ,at fair valve. The transaction costs are expensed immediately.os Chapter 1 Subsequent measurement > Finandal liabilities classified as amortized cost are subsequently measured at amortized cost. , .> Finandal liabilities classified as held for trading are subsequently measured at fair value with changes in fair values recognized in profit or loss. > Financial liabilities designated at FVPL are subsequently measured at fair value with changes in fair values recognized as follows: a. The amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability is presented in other comprehensi income, and _ b. The remaining. amount of change in the fair value of the liability is presented in profit or loss. Measurement of Non-financial liabilities a financial liabilities are initially measured at the best estimate ie amounts needed to settle those obligations or the aabattovent basis required by other applicable standard, e.g., deferred tax'liabilities are measured under PAS 12 Income Taxes. Examples of non-financial liabilities: a. Obligations arising from statutory requirements (e.g., income tax payable) geVernmen> by Warranty obligations ¢~Uneared or deferred revenues d. Commodity contracts that either cannot be settled in cash or which are expected to be settled by commodity exchange Subsequently, non-financial liabilities are also measured at the best estimate of the amounts needed to settle the obligations adjusted for any changes on the expected settlement amounts. Adjustments are treated as changes in accounting estimates and are'accounted for prospectively. Some non-financial liabilities are subsequently measured in accordance with the requirements ofCurrent Lit 15 other standards (e.g., deferred tax liabilities are measured in accordance with PAS 12). Financial statement presentation Liabilities are presented as either (a) current.or (b) nor noncurrent: on the face of a classified statement of financial position. A _clssified: statement of financial position is one that shows current and noncurrent distinctions. When an entity presents an unclassified statement of financial position (based on liquidity), disclosures of liabilities due within one year and due beyond one year should nevertheless be made in the notes. Eee Current I Current liabilities are liabilities that are: a, Expected to be settled in the entity’s normal operating cycle; b. Held primarily fo for trading; . & Due to-besettled with reporting period; or d. The entity does not have the right at the end of the reporting period to_defer settlement of the liability for at least twelve months after the reporting period. Cn ther liabilities are classified as noncurrent. “The operating cycle of an entity is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. When the entity’s normal operating cycle is not clearly identifiable, it is assumed to be 12 months,” (PAS 1.68) Liabilities ‘that are settled as part of the entity’s normal operating cycle (e.g,, trade payables and some accruals for employee and other operating costs) are presented as current, even if they are expected to be settled beyond 12 months after the end of the reporting period. Liabilities that do not form part of the entity’s.normal operating cycle (e.g., non-operating liabilities) are presented as in_12 months after the end of the%® Chapter 1 ~ current only when they are expected to be settled within 12 months after the end of the reporting period. Examples of current liabilities: a, Financial assets measured at FVPL (ie, designated or held for trading) d, Current portion of long-term notes, bonds, loans, and lease lnbilities a Trade accounts and notes payables a, Non-trade payables due within 12 months after the end of the reporting period e. Uneamed income expected to be eamed within 12 months after the end of the reporting period. f, Bank overdrafts Trade and non-trade payables Trade payables are obligations arising from purchases of inventory that are sold in the ordinary course of business. Other payables - are classified as non-trade. . Fora trading or manufacturing entity, trade and non-trade payables that are currently due are normally aggregated: and presented as one line item under the heading “Trade and other payables.” The reason for the trade and non-trade distinctions is the differing rules when dassitying payables as current or noncurrent, > Trade payables are classified as current liabilities when they are expected to be settled within the normal operating cycle or one year, whichever is longer, > On the other hand, non-trade payables are classitiod as current liabilities only when they are expected to be settled within one year. Finandial institutions need not classify-thetr payables as trade or non-trade because their statement of financial position is + presented based on liquidity, ie, no current and non-currentCurrent Liabilities ‘ 17 distinction. However, payables expected to be settled within one year and beyond one year are disclosed in the notes. Examples of payables Accounts payable — obligations not supported by formal promises to pay by the debtor. Notes payable - obligations supported by promissory notes by the debtor. Loans payable — usually used to connote bank loans. Bonds payable — obligations issued by the debtor supported by promises to pay made under seal. Liabilities under trust receipts, e.g., before the corresponding liability to the bank is paid, the goods are released to the buyer" in trust for. the bank which advanced the money for the importation of the goods. Other payables arising from sources other than purchases and borrowings, such as dividends payable, taxes payable, remittances payable, and accrued expenses. Illustration 1: Current liabilities Entity A has the following account balances on December 31, 20x1: a. 2. ropa me Trade accounts payable, net of P5,000 debit balance in supplier's account, P4,000 unreleased checks drawn, and P2,000 postdated checks drawn. 300,000 .. Credit balance in customers’ accounts 2,000 Financial liability designated at FVPL 50,000 Bonds payable (maturing in 10 equal annual installments of P100,000) 1,000,000 12%, 5-year note payable issued on October 1, 20x1 100,000 Deferred tax liability 5,000 Uneared rent 4,000 Contingent liability 10,000 Reserve for contingencies 25,000 Requirement: How much is the total current liabilities?18 Chapter 1 Solution: a. Trade accounts payable gross of debit balance, unreleased £311,000 check, and postdated check (300K + 5K + 4K + 2K). b. Advances from customers (Cr. bal. in customers’ accounts) 2,000 c. Financial liability designated at FVPL 50,000 d. Current portion of bonds payable 100,000 = Interest payable on the note in ‘e” (P100,000 x 12% x 3/12) 3,000 g- Unearned rent 4,000 Total current liabilities 470,000 & Notes: © Deferred tax liabilities are always presented as noncurrent when an entity presents a classified statement of financial position. © Contingent liability is not recognized but rather disclosed only in the notes. Reserve for contingencies is an appropriation of retained earnings and, thus, presented in equity. Illustration 2: Current liabilities ABC Co. has the following liabilities as of December 31 31, 20x1. a. Trade accounts payable, including cost of unsold goods received on consignment of P10,000 300,000 b. Held for trading financial liabilities 50,000 c. Deferred revenue 20,000 d. Bank overdraft 10,000 e. Income tax payable . 50,000 f. Accrued expenses . 5,000 g. Share dividend payable 12,000 hh. Advances from affiliates payable in 15 months after year-end 23,000 _ i, Loan of XYZ, Inc. guaranteed by ABC - it is possible __ that ABC will be held liable for the guarantee 45,000. Requirement: How much is the total current liabilities?