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Chapter 1 - Liabilities & Chapter 4 - Contingent Liability - Copy

Chapter 1 discusses liabilities, defining them as present obligations to transfer economic resources due to past events, distinguishing between accounts payable (AP) and accounts receivable (AR). It outlines the essential characteristics of liabilities, examples, classifications into current and non-current liabilities, and the impact of refinancing and covenants on liability classification. The chapter also covers estimated liabilities, deferred revenues, refundable deposits, and bonus computations, providing a comprehensive overview of how liabilities are recognized and reported in financial statements.
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0% found this document useful (0 votes)
11 views14 pages

Chapter 1 - Liabilities & Chapter 4 - Contingent Liability - Copy

Chapter 1 discusses liabilities, defining them as present obligations to transfer economic resources due to past events, distinguishing between accounts payable (AP) and accounts receivable (AR). It outlines the essential characteristics of liabilities, examples, classifications into current and non-current liabilities, and the impact of refinancing and covenants on liability classification. The chapter also covers estimated liabilities, deferred revenues, refundable deposits, and bonus computations, providing a comprehensive overview of how liabilities are recognized and reported in financial statements.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Chapter 1: Liabilities

Liabilities - Accounts Payable or PAYABLES


● debt
● present obligation of an entity to transfer an economic resource as a result of past events.
● AP VS. AR
AP AR
No allowance Has allowance for doubtful accounts
Why? @ entity's discretion Why? Naghihintay lang na magbayad si payor
Must always be the same amount as AR Must always be the same amount as AP

Essential characteristics of liability:


a. The entity - The entity liable must be identified.
has a - It is not necessary that the payee or the entity to whom the obligation is owed be
PRESENT identified.
obligation. - Obligation → is a duty or responsibility that an entity has no practical ability to
avoid
- can either be:
Legal Obligation Constructive Obligation
Arise as a consequence of a: Arise from:
contract statutory ● normal business
practice,
Ex: Ex: ● Customary purposes,
- Salary Expense - A tax liability ● a desire to maintain good
- accounts (earns = pays business relations or act in
payable for tax) an equitable manner.
goods and - 13th month Ex:
services pay ● an entity decides as a
received. matter of policy to rectify
faults in the products even
when these become
apparent after the warranty
period.
● Additional employee
payment (BONUS - not
mandatory)

b. The - Economic resource → the asset that represents a right with a potential to
obligation is produce economic benefit
to transfer an - transfer cash/non-cash
economic - deliver goods/services
resource. Declares Cash dividends
Declares Share dividends (part of equity)

c. The - a liability is not recognized until it is incurred.


obligation is a - obligating event → The past event that leads to a present obligation
present ● (creates a legal or constructive obligation → the entity has no realistic
obligation alternative but to settle the obligation created by the event)
that exists as ● Examples:
a result of o the acquisition of goods gives rise to accounts payable.
past event. ▪ The obligating event → the acquisition of goods.
o The receipt of a bank loan results in an obligation to repay
the loan.
▪ The obligating event→ the cash received from the bank as a
consequence of the bank loan.
EXAMPLES OF LIABILITIES
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. Dividends payable in cash or noncash asset
e. Deposits and advances from customers
f. Debt obligations for borrowed funds - notes, mortgages and bonds payable
g. Income tax payable
h. Deferred or unearned revenue

CL VS. NCL
CLASSIFICATION DEFINITION MEASUREMENT
CURRENT 1. expect to settle withing operating recorded at face amount
cycle ● Not discounted
2. holds primarily for the purpose of ● Face amount - present
trading value = immaterial,
3. due to be settled within 12 months ignore
4. no unconditional right to defer
settlement for at least 12 months after
reporting period (hindi pwedeng- ako
ang may utang, ako rin ang
magdedecide kung kailan ako
magbabayad)

PRESENTATION
line items for current liabilities are:
A. Trade and other payables
 is a line item for accounts
payable, notes payable, accrued
interest on note payable,
dividends payable and accrued
expenses.
 No objection can be raised if the
trade accounts and notes
payable are separately
presented.
B. Current provisions
C. Short-term borrowing
D. Current portion of long-term debt
E. Current tax liability

NON-CURRENT ● a residual definition. noninterest-bearing


● Long-term debt fallen due in one obligations
year ● initial: present value (PV)
● subsequent: amortized
PRESENTATION cost
line items for noncurrent liabilities are:
A. Noncurrent portion of long-term interest-bearing obligations
debt ● Initial & subsequent: face
B. Finance lease liability amount
C. Deferred tax liability
D. Long-term obligations to company
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
CONDITIONS
CL i. The original term was for a period longer than twelve months.

i. 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.

(Ineextend na bayarin sa utang. Babayarin mo pero uutangin ulit).


Reporting period - Dec. 31 2020.
Authorize to issue FS - March 31, 2021.
Settlement of Liability - Dec. 31, 2021.
Reschedule: Changing of Settlement of Liability to Dec. 31, 2023.
▪ Agreement to Refinance - Feb. 1, 2021.
= Current Liability of a long-term debt.

NCL 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.)
Reporting period - Dec. 31 2020.
Authorize to issue FS - March 31, 2021.
Settlement of Liability - Dec. 31, 2021.
Reschedule: Changing of Settlement of Liability to Dec. 31, 2023.
Agreement to Refinance - Nov. 30, 2020 - BEFORE THE END OF THE REPORTING
PERIOD.
= Noncurrent liability.

● DISCRETION TO REFINANCE:
If the entity has the classified as noncurrent even if it would otherwise be due within a
discretion to refinance or shorter period.
roll over an obligation for at ● Reason: the entity has an unconditional right under the
least twelve months after existing loan agreement to defer payment for at least
the reporting period under twelve months after the end of the reporting period.
an existing loan facility, ● Note that the refinancing or rolling over must be at the
discretion of the entity.

If the refinancing or rolling classified as a current liability.


over is not at the
discretion of the entity,

ILLUSTRATION
Covenants
● Are often attached to borrowing agreements which represent undertakings by the borrower.
● are actually restrictions on the borrower as to undertaking further borrowings, paying
dividends, maintaining specified level of working capital and so forth.
● if certain conditions relating to the borrower's financial situation are breached, the liability
becomes payable on demand (Current liability).

● Effect of breach of covenants:


CL if the lender has agreed,
● after the reporting period and
● before the statements are authorized for issue,
not to demand payment as a consequence of the breach.
● at reporting date the borrower does not have an unconditional right to defer
payment for at least twelve months after the reporting period.

NCL if the lender has agreed


● on or before the end of reporting period
to provide a grace period ending at least twelve months after the end of reporting
period.

ESTIMATED LIABILITIES
 exist at the end of reporting period (valid and unquestioned)
 although the amount is not definite
 due date is not definite or payee is not also identified
 examples: estimated liability for premiums, award points, warranties, gift certificates and
bonus
 GIFTS CERTIFICATES
 redeemable in merchandise
 has no expiration

DEFERRED/ UNEARNED REVENUE


● income/collection is received but not yet earned
● Current liability (realizable within 1 year)
● Unearned interest income
● Unearned rental income
● Unearned subscription revenue
● Noncurrent liability (realizable more than 1 year)
● Long-term service contracts
● Long-term leasehold advances
● adhering to revenue recognition principle (realizable more than 1 year)
● upon realized, there is a transfer from liability to income

REFUNDABLE DEPOSITS
● entity is the recipient of either cash or property which are bound to refund or recover by the latter
after compliance with certain conditions
● The best example = the customer deposit required for returnable containers like bottles,
drums, tanks and barrels.
 Illustration: A deposit of P10,000 is required from the customer for returnable containers. The
containers cost P8,000.
Cash 10,000

Containers' deposit - classified as current liability. 10,000


 If the customer returns the containers, the deposit is simply refunded.
 However, if the customer fails to return the containers, the deposit is considered the sale price of
the containers.
 The excess of the deposit over the cost of the containers is considered as gain.

BONUS COMPUTATION
 given as incentives to employees either as a result of past performance or to motivate employees
 4 variants of bonus computation:
 income before bonus and before tax
 income after bonus but before tax
 income after bonus and after tax
 income after tax but before bonus
 Illustration:
 Income before bonus and before tax - 4,400,000
 Bonus - 10%
 Income tax rate -25%
CASE 1:
income
income before bonus and before tax 4,400,000
before bonus
and before Tax rate x 10%
tax
Bonus 440,000

CASE 2: Formula:
income after Bonus = Bonus % (Income - Bonus)
bonus and
before tax B = 10% (4,400,000 - B)
B = 440,000 - 10%B
B + 10% B = 440,000
110%B = 440,000
110%B/110% = 440,000/110%
B = 400,000

income before bonus and before tax 4,400,000

Bonus (4,400,000 / 110% x 10%) (400,000)

income after bonus and before tax 4,000,00


0
Tax rate x 10%

Bonus 400,000

CASE 3: Formula:
income after Bonus = Bonus % (Income - Bonus - Tax)
bonus and Tax = Tax % (Income - Bonus)
after tax
B = 10% (4,400,000 - B - T)
T = 25% (4,400,000 - B)

B = 10% [4,400,000 - B - 25% (4,400,000 - B)]


B = 10% [4,400,000 - B - 1,100,000 + 25%B)
B = 440,000 - 10%B - 110,000 + 2.5%B
B + 10%B - 2.5%B = 440,000 - 110,000
107.5%B = 330,000

7.5%B/7.5% = 330,000/107.5%
B = 306,977

T = 25% (4,400,000 - B)
T = 25% (4,400,000 - 306,977)
T = 25% x 4,093,023
T = 1,023,255

income before bonus and before tax 4,400,000

Bonus (306,977)

Tax (1,023,255)

income after bonus and after tax 3,069,768

Tax rate x 10%

Bonus 306,977

CASE 4: Formula:
income after Bonus = Bonus % (Income - Tax)
tax but Tax = Tax % (Income - Bonus)
before bonus
Bonus = 10% (4,400,000 - T)
Tax = 25% (4,400,000 - B)

B = 10% (4,400,000 - T)
B = 10% [4,400,000 - 25% (4,400,000 - B)]
B = 10% (4,400,000 - 1,100,000 + 25%B)
B = 440,000 - 110,000 + 2.5%B
B - 2.5% B = 440,000 - 110,000 = 330,000
97.5% B = 330,000

97.5% B/97.5% = 330,000/97.5%


B = 338,462

T = 25% (4,400,000 - 338,462)


T = 25% x 4,061,538
T = 1,015,384
income after tax but before bonus 4,400,000

Tax (1,015,384)

Bonus 3,384,616

Tax rate x 10%

Bonus 338,462

CHAPTER 4: CONTINGENT LIABILITY


Asset Liability

90 - 100 Virtually certain R R

51 - 90 Probable D R

10 - 50 Possible Ignore D

0 - 10 Remote Ignore Ignore

PROVISION CONTINGENT LIABILITY CONTINGENT ASSET

− an existing liability of uncertain − possible obligations − possible asset that arises


timing or uncertain amount (50%) from past event and whose
− always answerable by “yes” − arises from past events existence will be confirmed only
− question is only when or how but existence will be by future events not wholly in the
much confirmed only by future control of the entity
− must be probable (50% + 1) events not wholly in the − not recognized (until realized
and measurable control of the entity or virtually certain)
− answerable by “yes” or − probable: disclosure
RECORDED IN FS AS: “no” − possible or remote: ignore
− either probable or
Expense - xx
measurable
Income
− not recognized but
statement
disclosed
Liability - xx − remote: (10%) no
Balance sheet disclosure

Provision or ESTIMATED LIABILITY


● Is an existing liability of uncertain timing or uncertain amount (of the future expenditure)
o There is a liability at the end of the reporting period, but the date, amount, and payee
cannot be identified.
● May be the equivalent of an estimated liability or loss contingency that is accrued
1. Present obligation
2. Both probable (The event is more likely than not to occur) AND measurable
Expense - Income statement xx

Liability - Balance sheet xx

Recognition of Provision AS LIABILITY:


a. Has present
obligation
Legal Obligation Constructive Obligation
(legal or
 Contract derived from an entity's action where:
constructive)
 legislation,  The entity has indicated to other parties
as a result of
 other that it will accept certain
past event -
operation of responsibilities by reason of
simple concept of
law o an established pattern of past
liability
practice,
o published policy, or
o sufficiently specific current
statement.

 And as a result, the entity has created a


valid expectation on the part of other
parties that it will discharge those
responsibilities.

 Past Event
 obligating event - The past event that leads to a
present obligation

 An accounting provision cannot be created in anticipation of a


future event.
 The event must have already occurred → gives rise to
the legal or constructive obligation.

 creates a legal or constructive obligation → the entity has


no realistic alternative but to settle the obligation created by the
event
 This is the case where:
o The settlement of the obligation can be enforced by law.
o The event creates valid expectations on the part of other
parties that the entity will discharge the obligation,
as in the case of a constructive obligation.

b. Probable  Probable
Outflow of  The event is more likely than not to occur,
resources is  will occur > will not occur
required to  more than 50% likely or substantially more
settle
obligations  Possible - 50% or less likely to occur
 Remote - 10% or less likely to occur

c. The amount  Essential part of preparing FS → use of estimate


of obligation  Use range of possible outcomes → estimate of obligation that
can be is sufficiently reliable.
measured  When no reliable estimate can be made = no liability is
reliably recognized.
(Reliable
estimate)

Measurement
● Best Estimate amount.
- of the expenditure required to settle the present obligation at the END of the reporting
period. The amount that an entity would rationally pay.
1. Single the individual most likely outcome adjusted for the effect of other possible
Obligation outcomes. → Best estimate

2. Continuous each point in that range is likely as any other → midpoint of the range
Range of (2,000,000 + 3,000,000 = 5,000,000 / 2 = 2,500,000)
possible
outcomes

3. Large weighting all possible outcomes by their associated possibilities.


Population of - Expected value - the statistical method of estimation.
items
 The present value in a range of possible outcomes all discounted using the same rate would be →
The sum of probability-weighted present value
ILLUSTRATION 1 - EXPECTED VALUE METHOD
An entity sells goods with a warranty under which customers are covered for the cost of repairs of
any manufacturing defects that become apparent within 6 months after purchase.
o If minor defects are detected in all products sold, repair costs would be about P1,000,000.
o If major defects are detected in all products sold, repair costs of P5,000,000 would result.

The entity's past experience and future expectations indicate that 75% of the goods sold will have no
defects, 20% will have minor defects and 5% will have major defects.

 The expected value or cost of repairs is measured by weighting all possible outcomes by their
associated probabilities.

75% sales None

20% sales 1,000,000 x 20% = 200,000

5% sales 5,000,000 x 5% = 250,000

Total expected value or cost of repairs 450,000

Illustration 2
An entity is a defendant in a patent infringement suit.
o The lawyers believe that there is a 60% chance that the court will not dismiss the case and
the entity will incur an outflow of future economic benefits.

If the court rules against the entity and in favor of the claimant, the lawyers believe that there is
o a 30% chance the entity will be required to pay damages of P4,000,000 and
o a 70% chance that the damages will be P2,000,000.

A 10% risk adjustment factor to the probabilities of the expected cash flows is considered appropriate
to reflect the uncertainties in the cash flow estimate.

Measurement of provision - weighted probabilities


4,000,000 x 30% x 60% 720,000

2,000,000 x 70% x 60% 840,000

Expected cash outflow 1,560,000

MULTIPLY BY: risk adjustment factor % x 10%

Expected cash outflow 156,000

Estimated amount of provision 1,716,000


o The weighted probability is multiplied by 60% because there is a 60% chance that the court will not
dismiss the case.
o The amount of the provision shall be discounted if the effect of the time value of money is
material.

Measurement Considerations
The following items are taken into consideration in recognizing and measuring a provision:
1. Risks and Shall be taken into account in reaching the best estimate of a provision.
uncertainties.
Risk describes variability of outcome.

A risk adjustment → may increase the amount at which a liability is


measured.
 As prudence dictates, caution is needed in making judgment under
conditions of uncertainty so that income and assets are not
overstated, or expenses and liabilities are not understated.

Uncertainty does not justify the creation of excessive provision or a


deliberate overstatement of liabilities.

2. Present value Where the effect of the time value of money is material, → the amount of
of obligation provision shall be the present value of the expenditure expected to
settle the obligation.

The discount rate should be a pretax rate → reflects the current market
assessment of the time value of money and the risk specific to the liability.
 Should NOT REFLECT THE RISK for which cash flow estimates have
already been adjusted.

Masettle sa matagal na panahon.


Time - factor.

3. Future events that affect the amount required to settle an obligation → shall be
reflected in the amount of a provision
 there is a sufficient evidence that they will occur.

Examples: new legislation, changes in technology, changes in tax rules.

4. GAINS FROM Shall NOT be taken into account.


Expected disposal  An entity shall recognize gain on disposal AT THE TIME of the disposal
of assets of the assets.
 Cash inflows from disposal → treated separately.

Examples: Decommissioning or abandonment cost.

5. Where some or all of the expenditure required to settle a provision is


Reimbursements expected to be reimbursed by another party, → the reimbursement
shall be recognized when it is virtually certain that reimbursement
would be received if the entity settles the obligation.
 treated as a separate asset
 not netted against the estimated liability for the provision.
 The amount of reimbursement shall not exceed the amount of the
provision.

 income statement → the expense relating to the provision may be


presented net of the reimbursement.

Liability: Insurance Company

6. Changes in shall be reviewed at every end of the reporting period and adjusted to
provision reflect the current best estimate.

The provision shall be reversed → if it is no longer probable that an


outflow of economic benefits would be required to settle the obligation.
 Where discounting is used, the carrying amount of the provision
increases each period to reflect the passage of time.

7. Use of shall be used only for expenditures for which the provision was
provision originally recognized.

Example: a provision for plant dismantlement cannot be used to absorb


environmental pollution claims or warranty payments.

If an expenditure is charged against a provision that was originally recognized


for another purpose, → that would camouflage the impact of two
different events = distorting financial performance and possibly
constituting financial reporting fraud.

Note: Provision's purpose - stays the same, only different uses.

8. Future shall NOT be recognized for future operating losses.


operating losses  because a past event creating a present obligation has not occurred.

 However, an expectation of future operating losses → an


indication that certain assets may be impaired.
o An impairment test for these assets may be necessary.

9. Onerous If an entity has an onerous contract, the present obligation under the contract
contract shall be recognized and measured as a provision.
 the unavoidable costs under a contract → represent the least net
cost of exiting from the contract.
o The lower amount between the cost of fulfilling the contract
and the compensation or penalty arising from failure to fulfill
the contract is the least cost of exiting from the contract.

Onerous contract
 Dangerous/talo ka.
 a contract in which the unavoidable costs of meeting the obligation
under the contract exceed the economic benefits expected to be
received under it.

Examples of Provision
1. Warranties The best estimate of the warranty cost is recognized as a provision

There is clear constructive obligation arising from an obligating event → the


sale of the product with warranty.

2. Environmental If an entity has an environmental policy such that other parties would expect
contamination the entity to clean up any contamination, or if the entity has broken current
environmental legislation then a provision for environmental damage
shall be made.

The obligating event → the contamination of the Property


 which gives rise to constructive or legal obligation.
 best estimate of the cost of cleaning up the contamination.

o An entity operates chemical plants. The published policies include a


commitment to making good any damage caused to the environment
by the operations. The entity has always honored this commitment.
Which of the following scenarios would give rise to an environmental
provision? → A chemical spill from one of the entity's plants has
caused harm to the surrounding area and wildlife.
3. shall be recognized as a provision.
Decommissioning
or abandonment When an oil entity initially purchases an oil field,→ it is put under a legal
costs obligation to decommission the site at the end of the life.
 Or ibabalik sa dati/ isasauli ang equipment.

4. Court case A provision is recognized for the best estimate of the damages
 there is a present obligation.

After a wedding in the current year, ten people died possibly as a result of
food poisoning from products sold by the entity.
 Legal proceedings are started seeking damages from the entity.

When the entity prepares the financial statements for the current year
→ the lawyers advise that owing to the developments in the case, it is
probable that the entity would be found liable.

5. Guarantee A provision is recognized for the best estimate of the guarantee obligation
 there is legal obligation arising from the obligating event which is the
guarantee.

In the current year, an entity gives a guarantee of certain borrowings of


another entity.
 During the year, the financial condition of the borrower deteriorates
and at year-end, the borrower files a petition for bankruptcy.

____________________________________________________________________________________________________________

Contingent Liability
Two definition:
a. Is a POSSIBLE obligation.
 That arises from past event
 Existence will be confirmed only by the occurrence or nonoccurrence of one or more
uncertain future events
 Not wholly within the control of the entity.

b. Is a PRESENT obligation.
 that arises from past event but is NOT recognized
 it is NOT probable that an outflow of resources embodying economic benefits will be
required to settle the obligation
 or the amount of the obligation CANNOT be measured reliably.

● Not a liability
● Not recognized in FS but shall be DISCLOSED ONLY when probable OR measurable.
o RECOGNIZED WHEN: The amount of the loss can be reliably measured and it is probable
prior to issuance of financial statements that a liability has been incurred
● DISCLOSURE IS NOT REQUIRED/ IGNORE:
o Contingent liability that is REMOTE (10%)

 The required disclosures are:


a. Brief description of the nature of the contingent liability.
b. An estimate of its financial effects.
c. An indication of the uncertainties that exist.
d. Possibility of any reimbursement.
 DISCLOSURE IS NOT REQUIRED/ IGNORE:
o Contingent liability that is REMOTE (10%)

Illustration:
● Present obligation: either PROBABLE or MEASURABLE; but NOT BOTH → CONTINGENT LIABILITY
▪ Do all people pass the CPA board exam?
▪ answerable by “yes” or “no”
● Present obligation: PROBABLE & MEASURED RELIABLY → PROVISION
▪ Do all people die?
▪ always answerable by “yes”

____________________________________________________________________________________________________________

Contingent Asset
 Not recognized in FS as an asset but shall be DISCLOSED ONLY.

 a possible asset
o arises from past event
o whose existence will be confirmed only by the occurrence or nonoccurrence of one or more
uncertain future events
o not wholly within the control of the entity

 shall not be recognized


o this may result to recognition of income that may never be realized.

 When the realization of income is virtually certain → the related asset is no longer contingent
asset
o its recognition → ASSET

 A contingent asset
→ probable: DISCLOSURE REQUIRED
o Includes:
i. a brief description of the contingent asset
ii. an estimate of its financial effects

→ ONLY possible or remote: NO disclosure is required - IGNORE.

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