Module 6 – Current Liabilities

Learning Outcomes:
 Define liabilities and explain their essential characteristics
 Identify the recognition criteria for liabilities
 Distinguish current liabilities from non-current liabilities
 Distinguish provisions from contingent liabilities

Core Value/Biblical Principles:

Philippians 4:6-7

Do not be anxious about anything, but in everything by prayer and supplication with
thanksgiving let your requests be made known to God. And the peace of God, which surpasses
all understanding, will guard your hearts and your minds in Christ Jesus.
 Liabilities represent amounts an entity owes for its debts or obligations. The
International Accounting Standards Board acknowledges the fact that information about
expected dates of realization of assets and liabilities is useful in assessing the liquidity
and solvency of an entity (par. 65, IAS 1 Presentation of Financial Statements). This is
the reason for the classification of assets and liabilities into current and non-current,
except when a presentation based on liquidity provides information that is reliable and
more relevant.

DEFINITION AND NATURE OF LIABILITIES

The IASB’s Conceptual Framework for Financial Reporting defines liability as “present
obligation of an enterprise arising from past event, the settlement of which is expected to result in an
outflow from the enterprise of resources embodying economic benefits”.

From the definition given, a liability possesses the following essential characteristics:

1. Present obligation
2. Past event
3. Probable outflow of resources embodying economic benefits

An obligation is a duty or responsibility to act or perform in a certain way which

may be legally enforceable as a consequence of a binding contract or statutory
requirement; or it may be an obligation acknowledged by an enterprise because other
parties are made to believe that it will carry out an undertaking or certain action.

An obligating event is one that results in an enterprise having no realistic

alternative to settling that obligation. An obligating event may be classified in either of the
following:

1. Legal obligation; or
2. Constructive obligation

A legal obligation is one that derives from a contract (through its explicit or implicit
terms), legislation, or other operation of law. Examples of liabilities that arise from legal
obligations are accounts payable (arising from a contract with a supplier), withholding
taxes payable and value added taxes payable (arising from legislation and other operation
of law).

A constructive obligation is one that derives from an enterprise’s actions whereby an

established pattern of past practice, published policies or sufficiently specific current statement, the
enterprise has indicated to other parties that it will accept certain responsibilities and as a result, the
enterprise has created a valid expectation on the pat of those other parties that it will discharge those
responsibilities (paragraph 10, IAS 37, Provisions, Contingent Liabilities and Contingent Assets). An
example of a liability that is recognized as a constructive obligation is provision for clean up costs
where the enterprise has a widely published policy of cleaning up all contamination that it causes.

Liabilities arise only from past events or transactions. For example, the mere signing of a
purchase contract with a supplier does not give rise to a liability. The liability will arise if the entity
acquires legally or constructively the title to the goods from the supplier, the past event in that case is
the acceptance by the entity of the goods delivered by the supplier. In a similar manner, the mere
signing of an employment contact with an employee does not give rise to a liability. The liability for
salaries shall be recognized when the employees render services to the entity.

The settlement of a present obligation involves the enterprise giving up resources

embodying economic benefits in order to satisfy the claim of the other party.
Settlement of a present obligation may occur in a number of ways, such as by

(a) Payment of cash;

(b) Transfer of other assets;
(c) Provision of services;
(d) Replacement of an obligation with another obligation; and
(e) Conversion of the obligation to equity.

In some exceptional cases, an obligation is settled through condonation by the creditor.

An obligation always involves another party to whom the obligation is owed. However, it
is not necessary to know the identity of the party to whom the obligation is owed for it to qualify as
a liability.

RECOGNITION OF LIABILITIES

A liability is recorded and reported in the statement of financial position when a past event has
occurred and the following conditions are met:

(1) It is probable that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation; and

(2) The amount at which the settlement will take place can be measured reliably.

An outflow of resources is considered probable when the event is more likely to

occur than not to occur (i.e., the probability is more than 50%). In certain cases, an
enterprise considers the opinions of experts or the evidences provided by events after the
reporting period.

Measurement is a sub-process in the process of recognition. Measurement is the

assigning of peso amount to a financial statement element. It is not necessary, however,
that the amount of the probable obligation be measured with preciseness. The use of
estimates may sometimes be essential and does not undermined the reliability of the
financial statements. In other instances, the timing of the settlement of the obligation may
not be certain, as in obligations for product warranties, where customers are allowed to
avail of the warranty within a specific period but not necessarily at a definite date. The
uncertainty of the timing and/or the amount of the obligation does not disqualify the
obligation to be recognized as accounting liabilities. These liabilities, which are uncertain as
to timing or amounts, are otherwise known as provisions. In the past, this item is better
known as estimated liability.

When a past event has occurred but it is not probable that an outflow of resources
embodying economic benefits will result or the amount of the settlement cannot be
measured reliably even with the use of estimates, no recognition of liability is made in the
 financial statements. Such a case gives rise to a contingency that may require disclosure in
the notes to the financial statements.

Provisions Distinguished From Contingent Liabilities

Obligations involving uncertainties are either provisions or contingent liabilities.

When it is probable that an outflow of resources embodying economic benefits will result
from the settlement of an obligation, but the amount of the outflow could be measured
only based on reasonable estimates, or the timing of the settlement is not definite, the
obligation is recognized as a provision. Thus, a provision is an obligation whose existence is
certain as of the end of the reporting period, and only the timing of settlement or the
amount to be settled is uncertain. The amount of the obligation, however, is reliably
estimable.

When the existence of the obligation is uncertain as of the end of the reporting
period, or when the amount of the obligation cannot be reasonably estimated, even if it is
probable to result in an outflow if resources embodying economic benefits, no recognition
of obligation is required in the financial statements. The item is one of a contingent liability.
Contingent liabilities must be assessed continually to determine whether an outflow of
resources embodying economic benefits has become probable. If it becomes probable that
an outflow of future economic benefits will be required for an item previously dealt with as
a contingent liability, a provision is recognized in the financial statements of the period in
which the change in probability occurs, except in the extremely rare circumstances where
no reliable estimate can be made.

For example, during 2020, ABC Company gives a guarantee of certain borrowings
of DEF Company, whose financial condition at that time is sound. During 2021, the financial
condition of DEF Company deteriorates and at June 30, 2021, DEF Company files for
protection from its creditors.

At December 31, 2020, the obligating event is the giving of the guarantee that
gives rise to a legal obligation. However, no outflow of benefits is probable on this date;
thus, no provision is recognized. The guarantee is disclosed as a contingent liability, unless
the probability of any outflow is regarded as remote.

At December 31, 2021, however, it is probable that an outflow of resources

embodying economic benefits will be required to settle the obligation. On this date, a
provision is recognized for the best estimate of the obligation.

Similarly, provisions should be reviewed at the end of each reporting period and
adjusted to reflect the current best estimate. If it is no longer probable that an outflow of
resources embodying economic benefits will be required to settle the obligation, the
provision should be reversed. The reversal is treated as change in accounting estimate and
will affect the profit or loss of the current period.

MEASUREMENT OF LIABILITIES

Liabilities are measured

(1) At amounts established in exchanges (amount to be paid or amount to discounted); or
(2) By estimates of a definitive character when the amount of the liability cannot be measured
more precisely (provision).
Measurement of Provisions

 The amount recognized as a provision should be the best estimate of the expenditure
required to settle the obligation at the end of the reporting period, considering
- Judgement of the management of the enterprise;
- Experience of similar transactions; or
- Reports from independent experts

 If a single obligation is being measured, the amount to be recognized as a liability is

the most likely outcome.

 Where the amount of the obligation is still uncertain as of the end of the reporting
period, but the obligation is settled subsequently before the issuance of the financial
statements, the amount shown in the statement of financial position is the amount
actually settled subsequently.

 Where the provision being measured involves a large population of items, the
obligation is estimated by weighting all possible outcomes by their associated
possibilities (statistical method called “expected value”) 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 effect of the time value of money is material, the amount of a provision
should be the present value of the expenditures expected to be required to settle the
obligation.

 Where some or all of the expenditure required to settle a provision is expected to be

reimbursed by another party, the reimbursement should be recognized when, and only
when, it is virtually certain that reimbursement will be received if the enterprise settles
the obligation. The reimbursement, if virtually certain, should be treated as a separate
asset. The amount recognized for the reimbursement should not exceed the amount of
the provision.
The following illustrates the principles discussed above:

Case 1. In September 2020, Howell filed a suit against Blue Company alleging violation of
patent rights and it is seeking payment for damages of P7,000,000. Blue disclaims the
charges and the legal counsel advises that as of the date of issuance of Blue
Company’s financial statements, it is probable that the enterprise will not be found
liable.

No provision is recognized because based on the evidence available as of the financial

statement date, there is no obligation as a result of past events. The matter is
disclosed as a contingent liability, unless the probability of any outflow is regarded as
remote.

Case 2. ABC Company operates in a city where there is no environmental legislation. However,
the company has a widely published policy in which it undertakes to clean up all
contamination it causes. AS of the date of the issuance of 2020 financial statements, a
reasonable estimate of the cost of this clean up related to 2020 operations is
P2,000,000.

A provision is recognized for the estimated amount of the costs of the clean-up, which is
P2,000,000. The obligating event is one of a constructive obligation. The entry for the
recognition of the provision is

Environmental Clean-up Expense 2,000,000

Provision for Environmental Clean up 2,000,000

Case 3 As a result of an uninsured accident during the year 2020, personal injury suit
for P3,000,000 has been filed against XYZ Company. It is the judgment of the
company’s legal counsel that an unfavorable verdict will result in a loss
ranging from P1,800,000 to P2,800,000. The lawyer believes that the most
reasonable estimate is P2,200,000.

A provision is recognized for the best estimate of the obligation. The best
estimate is the most likely outcome which is P2,200,000. The entry for the
provision is

Loss from Accident 2,200,000

Provision for Damages 2,200,000

Additional possible obligation of P600,000 (the difference between the

recorded amount of P2,200,000 and the highest range of estimated amounts
of P2,800,000) is to be disclosed in the notes to the financial statements.
Case 4. GHI Company sells goods with a warranty under which customers are covered
for the cost of any manufacturing defects that become apparent within the
first year after purchase. If minor defects were detected in all products sold,
repair costs of P2 million would result. If major defects were detected in all
products sold, repair costs of P5 million would result. The enterprise’s past
experience and future expectations indicate that 60% of the goods sold have
no defects, 30% of the goods sold have minor defects and 10% of the goods
sold have major defects.

It is probable that the sale of defective merchandise will result in an outflow of

economic benefits. Thus, the sale created an obligation. The best estimate of
the obligation is the “expected value of the outcome”, which is derived by
weighting all possible outcomes by their associated probabilities. Thus, the
provision shall be measured as follows:

No defects P0 x 60% P 0
Minor defects P2M x 30% P600,000
Major defects P5M x 10% P500,000
Amount of provision P1,100,000

The entry to recognize the provision is

Warranty Expense 1,100,000

Provision for Warranty 1,100,000

Case 5.
JKL is charged with multiple lawsuit because of an incident that happened in
February 2020, causing death of about 8- persons due to stampede in a sales
promotion program it was airing through Channel 6 on February 10, 2021.
Based on similar incidents suffered by other entities, JKL’s legal counsels are
of the opinion that it is probable that JKL would be found liable for the
incident. AS of the date of the issuance of the 2020 financial statements, a
reasonable estimate of the obligation is between P16,000,000 to P24,000,000.
Each point within the range is as likely as any other.

The provision being measured above involves a large population of items and
there is a continuous range of possible outcomes. There is no better estimate
in the range, and each point within that range is as likely as any other point.
Thus the provision shall be measured at the midpoint of the range. The
midpoint is the simple average or the mean, thus (P16,000,000 +
P24,000,000) divided by 2 equals P20,000,000.

The entry to set up the provision is

Loss from Damages 20,000,000

Provision for Damages 20,000,000
Review of the Amount Previously Recognized as Provision

If based on subsequent review of the amount of the provision, there is a need to

adjust the previously recorded amount, the adjustment is treated as change in accounting
estimate and would affect profit or loss of the current year. Thus, if based on the review of the
provision, the amount needs to be decreased, the entry in a subsequent reporting period is to
debit the provision and credit an appropriate expense, loss or in some cases, an income
account.

If at the end of the reporting period, it is no longer probable that an outflow of

resources will be required to settle the obligation, the provision previously recognized should
be reversed.

CLASSIFICATION OF LIABILITIES

To help users better evaluate an entity’s financial position, the entity shall present
current and non-current assets and current and non-current liabilities as separate
classifications in its statement of financial position unless a presentation based on liquidity is
considered more relevant to the users.

An enterprise shall classify a liability as current when (par. 69, IAS 1):

(a) It expects to settle the liability in its normal operating cycle

(b) It holds the liability primarily for the purpose of trading
(c) The liability is due to be settled within 12 months are the reporting period or
(d) It does not have an unconditional right to defer settlement of the liability for at
least 12 months after the reporting period.

Trade payables are generally classified as current liabilities even if they are not due for
settlement within 12 months from the end of the reporting period, because settlement of
these obligations is expected within the entity’s normal operating cycle. Liabilities of this type
include trade accounts and notes payable extended within the usual credit terms of the
supplier, and accruals for employees’ wages and other operating costs.

Non-trade obligations that are due for settlement within twelve months from the
end of the reporting period (regardless of the length of the operating cycle of the entity)
also form part of current liabilities. These include short-term, non-trade note payables,
deposits and advances and portion of long-term debt due within 12 months from the
reporting date.

Liabilities are held for trading if they are incurred principally for the purpose of
selling or repurchasing in the near term, or are part of the portfolio of identified financial
instruments that are managed together and for which there is evidence of a recent pattern
of actual profit-taking. These types of liabilities include deposits received by banks which
are held under trust funds and are invested by banks, in behalf of the depositors, in some
short-term financial instruments. Liabilities held for trading also include derivatives.

A long-term liability maturing within twelve months from the reporting date is
generally classified as part of current liabilities. However, if at the reporting date, the entity
has the right to defer settlement of the obligation for a period of more than twelve months
from such date, the liability shall be classified as non-current. The right to postpone the
settlement of the obligation may arise because of refinancing agreement entered into by
 the enterprise. Refinancing takes the form of either extending the maturity date or entering
into a borrowing transaction, proceeds of which will be used to settle the maturing
obligation.
The currently maturing obligation shall be reported as non-current only if the
agreement to refinance on or before the reporting date. If the agreement to refinance is
completed after the reporting period, even before the issuance of the financial statements,
the maturing obligation shall be classified as current, because as of the end of the reporting
date, the enterprise does not have the right to defer settlement of the liability. Likewise, if
an entity expects, and has the discretion, to refinance or roll over an obligation for more
than twelve months after the reporting date under an existing loan facility, it classifies the
obligation as non-current, even if it would be due within a short period.

Furthermore, when an entity breaches an undertaking under a long-term loan

agreement on or before the reporting date with the effect that the liability becomes payable
on demand, the liability is classified as current, even if the lender has agreed, after the
reporting period and before the authorization of the financial statements for issue, not to
demand payment as a consequence of the breach. The liability is classified as current
because, at the reporting date, the entty does not have an unconditional right to defer its
settlement for at least twelve months after that date.

However, the liability is classified as non-current if the lender agreed at or before

the reporting date to provide a grace period ending at least twelve months from that date,
within which the entity can rectify the breach and during which the lender cannot demand
immediate payment.

To illustrate the foregoing, assume the following independent situations. After each
situation, the disposition for the classification of each item in the statement of financial
position is presented. The statement is dated December 31, 2020.

Case 1. Dorina, Inc. has P4 million of notes payable due June 15, 2021. At December 31,
2020, Dorina signed an agreement to borrow up to P4 million to refinance the notes
payable on a two-year basis. The financing agreement called for borrowings not to
exceed 75% of the value of the collateral Dorina was providing. At the date of issue of
the December 31, 2020 financial statements, the value of the collateral was P4.8
million and was not expected to fall below this amount.

Because as of December 31, 2020, the reporting date, Dorina has the discretion to defer
the settlement of a portion of the maturing obligation for a period of more than 12
months, that portion shall be classified as non-current. Of the P4 million payable,
P3,600,000 (which is 75% of P4.8M) shall be classified as non-current while the
remaining P400,000 shall be classified as current liabilities.
Case 2. Dorina Inc. has P4 million of notes payable due June 15, 2021. At February 15, 2021,
Dorina signed an agreement to borrow up to P4 million to refinance the notes payable
on a long-term basis. The financing agreement called for borrowings not to exceed
75% of the value of the collateral Dorina was providing. The value of the collateral as
P4.8 million and was not expected to fall below this amount. The financial statements
are authorized for issuance on March 5, 2021.

On the December 31, 2020, statement of financial position the full amount of P4
million shall be classified as current liabilities even if the enterprise signed an
agreement to refinance the maturing notes payable on a long-term basis before the
issuance of the 2020 financial statements. The full amount is classified as a current
liability because as of December 31, 2020, Dorina has no unconditional right yet to
defer the settlement of the P4 million. The refinancing of the P4 million is considered
as an event after the reporting period not requiring adjustment in the financial
statements. This refinancing after the reporting period, if considered significant,
qualifies for disclosure in the notes to the financial statements

Case 3. In October 2018, Vivian Corp. acquired a special equipment from Carlo, Inc. by paying
P1,000,000 down and signing a note with a face value of P4,000,000 due on October
2021. Under the terms of the financing agreement, Vivian has the discretion to roll
over the obligation for at least fifteen months. In October 2020, management decides
to exercise its discretion to roll over the liability up to October 31, 2022.

The P4,000,000 note is classified as non-current on December 31, 2020 statement of

financial position. The enterprise already exercised its discretion as the reporting date
(December 31, 2020) to roll over the obligation. The maturity date of the obligation
have been reset to October 31, 2022, which is 22 months away from December 31,
2020, the reporting date.

Case 4. In October 2018, Vivian Corp. acquired a special equipment from Carlo, Inc. by paying
P1,000,000 down and signing a note with a face value of P4,000,000 due on October
2020. The existing loan agreement does not carry a provision to refinance. In October
2020, Vivian was experiencing financial difficulty and was unable to pay the maturing
obligation. On February 1, 2021, Carlo has agreed not to demand payment for at least
12 months as a consequence of the breach of payment on the principal of the loan.
The financial statements were authorized for issue on March 31, 2021.

The P4,000,000 note payable shall be classified on Vivian’s December 31, 2020
statement of financial position as current liabilities. It is classified as current, because
as of December 31, 2020, the entity has no discretion yet to roll over the obligation
for at least twelve months after that date.
Case 5. In October 2018, Vivian Corp. acquired a special equipment from Carlo, Inc. by paying
P1,000,000 down and signing a note with a face value of P4,000,000 due on October
2020. The existing loan agreement does not carry a provision to refinance. In October
2020, Vivian was experiencing financial difficulty and was unable to pay the maturing
obligation. On December 31, 2020, Carlo signed an agreement to provide Vivian a
grace period of 15 months from that date, during which period, Carlo will not demand
immediate payment in order to give Vivian the chance to rectify the breach. The
financial statements were authorized for issue on March 31, 2021.

In the December 31, 2020 statement of financial position of Vivian, the P4,000,000
note payable shall be classified as non-current, because Carlo agreed not to demand
payment for 15 months from December 31, 2020. Thus under the new terms offered
by the creditor, Vivian is given a grace period of 15 months, within which the creditor
could not demand immediate payment.

Case 6. On October 1, 2018, Vilma Corporation acquired land from Fortune Corporation by
paying P1,000,000 down and signing a note with a face value of P6,000,000 due in
installments of P1,000,000 plus annual interest on the balance of the principal at the
rate of 10%, the first installment being due on September 30, 2019. The existing loan
agreement does not carry a provision to refinance and further states that any failure
to pay the required installment and interest will make the full amount of the loan due
and demandable. Further, the full amount of the principal and accrued interest shall
be subject to interest of 10%. As of December 31, 2020, Vilma Corporation is already
three months behind in the payment of the 2020 annual installment and interest.

The violation of the debt agreement makes the obligation due and demandable. The
remaining balance of the loan principal amounting to P5,000,000 plus accrued interest
of P500,000 shall be subject to further interest of 10%, Thus the total amount of
obligation related to this note of P5,637,500 which is P5,500,000 + (P5,500,000 x
10% x 3/12) shall be classified as current liabilities.

If the following events occur between the end of the reporting period and the date the
financial statements are authorized for issue, these events are disclosed as non-adjusting events
in the notes to the financial statements (par 76 IAS1):

(a) Refinancing on long-term basis

(b) Rectification of a breach of long-term loan arrangement
(c) The granting by the lender of a period of grace to rectify a breach of a long-term loan
arrangement ending at least 12 months after the reporting period.

Also, any liability that has been excluded from current liabilities as a result of refinancing should be
described and disclosed in the notes to the financial statements.
Presentation based on Liquidity

The general rule for the presentation of assets and liabilities on the face of the financial
statements is to classify them into current and non-current. An exception to this rule applies when the
enterprise believes that presentation based on liquidity provides information that is more reliable and
more relevant. When this exception applies, an entity shall present all assets and liabilities in the
order of liquidity.

Whichever method is adopted for the presentation of assets and liabilities, IAS 1 requires for
each asset and liability that combines

(1) Amounts expected to be recovered or settled within 12 months from the reporting date; and
(2) Amounts expected to be recovered or settled more than 12 months after the reporting date

Disclosure of that amount to be recovered or settled after more than 12 months. For example, if an
enterprise presents a single line item trade notes payable in the current liabilities section of the
statement of financial position as of December 31, 2020, it shall disclose what amount, if any, of the
notes payable expected to be settled after December 31, 2021.

SUMMARY

 A liability is a present obligation of the enterprise arising from past events, the settlement of
which is expected to result in an outflow from the enterprise of resources embodying economic
benefits. It is recognized when an enterprise has a present obligation as a result of past event,
it si probable that an outflow of resources embodying economic benefits will be required to
settle the obligation, and a reliable estimate can be made of the amount of the obligation.

 Contingent liabilities are those whose existence will be confirmed only by the occurrence or
non-occurrence of one or more uncertain future events not wholly within the control of the
enterprise. The also include liabilities that are not recognized because they do not meet one or
both of the recognition criteria. An enterprise should not recognize a contingent liability. It is
only disclosed, unless the possibility of an outflow of resources embodying economic benefits
is remote.

REFERENCE

Intermediate Accounting Vol. 3, 2015 ed., Nenita S. Robles, Patricia M. Empleo