CHAPTER 4

LIABILITIES

Liabilities are defined as “present obligations of an entity arising from past transactions or
events, the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits”. The essential characteristics of a liability are:

(a) The liability is the present obligation of a particular entity.

An obligation is a duty or a responsibility to act or perform in a certain way. It can
arise from legally enforceable contract or requirement such as accounts payable, loans
payable, notes payable, income tax payable, etc. It can also be incurred through normal
business practices, customs and desires to maintain good business relations or to act in
an equitable manner for instance, estimated warranty and premiums payable. As a present
obligation, liabilities normally arise only when the asset is delivered or the entity enters
into an irrevocable agreement to acquire the asset. In which case, a decision by
management of an entity to acquire assets in the future does not of itself give rise to a
present obligation.

(b) The liability arises from past transaction or event.

A liability is a result from a past transaction or event such as the acquisition of
goods and the use of services give rise to trade payables (unless paid for in advance or on
delivery) and the receipt of a bank loan results in an obligation to repay the loan.

(c) The settlement of the liability requires an outflow of resources embodying economic
benefits.
The settlement of a present obligation usually involves the entity 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, for example, by:
 payment of cash;
 transfer of other assets;
 provision of services;
 replacement of that obligation with another obligation; or
 conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a creditor

waiving or forfeiting its rights.

RECOGNITION

A liability is recognized in the statement of financial position when it is probable that an outflow
of resources embodying economic benefits will result from the settlement of a present obligation
and the amount at which the settlement will take place can be measured reliably.
MEASUREMENT

Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in
some circumstances (for example, income taxes), at the amounts of cash or cash equivalents
expected to be paid to satisfy the liability in the normal course of business. Some liabilities can
be measured only by using a substantial degree of estimation such as provisions.

CLASSIFICATION AND PRESENTATION

PAS 1, states that an entity shall present current and non-current liabilities as separate
classification in the statement of financial position except when a presentation based on liquidity
provides information that is reliable and more relevant. An entity shall not classify deferred tax
assets (liabilities) as current assets (liabilities).

Current and Non-current liabilities

An entity shall classify a liability as current when:

(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 twelve months after the reporting period; or
(d) it does not have an unconditional right to defer settlement of the liability for at least
twelve months after the reporting period. Terms of a liability that could, at the option of
the counterparty, result in its settlement by the issue of equity instruments do not affect
its classification.

An entity shall classify all other liabilities as non-current liabilities.

An entity classifies its financial liabilities as current when they are due to be settled within
twelve months after the reporting period, even if:
(a) the original term was for a period longer than twelve months, and
(b) an agreement to refinance, or to reschedule payments, on a long-term basis is completed
after the reporting period and before the financial statements are authorized for issue.

If an entity expects, and has the discretion, to refinance or roll over an obligation for at least
twelve months after the reporting period under an existing loan facility, it classifies the
obligation as non-current, even if it would otherwise be due within a shorter period.

When an entity breaches a provision of a long-term loan arrangement on or before the end of the
reporting period with the effect that the liability becomes payable on demand, it classifies the
liability as current, even if the lender 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.

However, an entity classifies the liability as non-current if the lender agreed by the end of the
reporting period to provide a period of grace ending at least twelve months after the reporting
period, within which the entity can rectify the breach and during which the lender cannot demand
immediate repayment.

Current and non-current liabilities are generally classified and presented under the headings:
Current liabilities: Non-current liabilities:
- Trade and other payables* - Non-current portion of long-term debt
- Provisions** (Notes, Bonds, Mortgage, Finance lease etc.)
- Current portion of long term debt - Deferred tax liability
(Notes, Bonds, Mortgage, Finance Lease etc.) - Other non-current liability
- Income tax liability

*Includes accounts payable, notes payable, salaries payable, wages payable, withholding tax payable and other
accruals which are part of the entity’s normal operating cycle.
** Provisions includes estimated warranty liability, estimated premium liability and other estimated liabilities.

Illustrative Problem:

The accountant for Sire Corp. prepared the following schedule of liabilities as of
December 31, 2015.
Accounts payable P 65,000
Notes payable- trade 19,000
Notes payable- bank 80,000
Wages and salaries payable 1,500
Interest payable 14,300
Mortgage payable- 10% 60,000
Mortgage payable- 12% 150,000
Bonds payable 200,000
Total P 589,800

The following additional information pertains to these liabilities.

(a) All trade notes payable are due within six months of the balance sheet date.
(b) Bank notes payable include two separate notes payable to First Interstate Bank.
a. A P30,000, 8% note issued March1, 2013, payable on demand. Interest is payable
every six months.
b. A one-year, P50,000, 11 1/2% note issued January 2, 2015. On December 30,
2015, Sire negotiated a written agreement with First Interstate Bank to replace the
note with a two-year, P50,000, 10% note to be issued January 2, 2016.
(c) The 10% mortgage note was issued October 1, 2012, with a term of 10 years. Terms of
the note give the holder the right to demand immediate payment if the company fails to
make a monthly interest payment within 10 days of the date the payment is due. As of
December 31, 2015, Sire is three months behind in paying its required interest payment.
(d) The 12% mortgage note was issued May 1, 2009, with a term of 20 years. The current
principal amount due is P150,000. Principal and interest are payable annually on April
30. A payment of P22,000 is due April 30, 2016. The payment includes interest of
P18,000.
 (e) The bonds payable are 10-year, 8% bonds, issued June 30, 2006.

Required:
1. Compute the amount to be presented as current liabilities as of December 31, 2015.
2. Compute the amount to be presented as non-current liabilities as of December 31, 2015.

Solution:
1. Current liabilities:
Accounts payable P 65,000
Wages and salaries payable 1,500
Interest payable 14,300
Notes payable- trade 19,000
Notes payable- bank, 8%* 30,000
Mortgage payable- 10%** 60,000
Mortgage payable- 12%, current portion*** 4,000
Bonds payable 200,000
Total P393,800

Accounts payable, wages and salaries payable, and interest payable are part of the normal operating cycle.
* Liabilities payable on demand are current.
** Breach of agreement converts the obligation to payable on demand.
*** Due to be settled within 12 months from the reporting date (P22,000 less P18,000 applicable to
interest).

2. Non-current liabilities:
Notes payable- bank, 11 1/2%* P50,000
Mortgage payable- 12% , non-current portion 146,000 (P150,000- 4,000)
Total P196,000

* Refinancing on a long-term basis was completed on or before the reporting period.

PROVISIONS

The Standard defines provisions (or estimated liabilities) as liabilities of uncertain timing or
amount. A provision should be recognized when, and only when:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable (ie more likely than not) that an outflow of resources embodying economic
benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation. The Standard notes that it
is only in extremely rare cases that a reliable estimate will not be possible.

If these conditions are not met, no provision shall be recognized. Provisions shall 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 shall be reversed. Examples of provisions include estimated warranty
liability and estimated premium liability.

Estimated Warranty Liability

Many companies agree to provide free service on units failing to perform satisfactorily or to
replace defective goods. When these agreements, or warranties, involve only minor costs, such
costs may be recognized in the periods incurred. When these agreements involve significant
future costs and when experience indicates that a definite future obligation exists, estimates of
such costs should be made and matched against current revenues.

Such estimates are usually recorded by a debit to an expense account and a credit to a liability
account. Subsequent costs of fulfilling warranties are debited to the liability account and credited
to an appropriate account, for example, Cash or Inventory.

Illustrative Problem:

Meow sells compact stereo systems with a two-year warranty. Past experience indicates that 10%
of all systems sold will need repairs in the first year and 20% will need repairs in the second
year. The average repair cost is P50 per system. The number of systems sold in 2014 and 2015
was 5,000 and 6,000, respectively. Actual repair costs were P12,500 in 2014 and P55,000 in
2015; it is assumed that all repair costs involved cash expenditures.

Required:
1. Journal entries to record the transactions.
2. Presentation of warranty related transaction in the financial statements.

Solution:
1. Journal entries to record the transactions.

2014 Warranty expense (5,000 x 0.30 x P50) 75,000

Estimated warranty liability 75,000
To record warranty provision during 2014.

- Estimated warranty liability 12,500

Cash 12,500
To record actual warranty repairs in 2014.

2015 Warranty expense (6,000 x 0.30 x P50) 90,000

Estimated warranty liability 90,000
To record warranty provision during 2015.

- Estimated warranty liability 55,000

Cash 55,000
To record actual warranty repairs in 2015.
 2. Presentation of warranty related transaction in the statement of financial position.

2014 2015_
Income statement
Selling and marketing expenses:
Warranty expense P75,000 P90,000
Statement of Financial Position
Current liabilities:
Estimated Warranty Liability* P62,500 P97,500

* Estimated warranty liability, beg + Provision for the year - Actual warranty expenditure. In 2014,
P-0- + P75,000 - P12,500= P62,500 and in 2015, P62,500 + P90,000 – P55,000= P97,500.

Estimated Premium Liability

Companies offer premiums, coupon offers, and rebates to stimulate sales. To match costs with
revenues, the cost of the premiums are charge to expense in the period of sale rather than on the
period of redemption. The company then charges the cost of premium offers to Premium
Expense. It credits the outstanding obligations to an account titled Estimated Premium Liability.

Illustrative Problem:

Pillsbury Cakemix Company offered its customers a large nonbreakable mixing bowl in
exchange for P25 and 10 labels. The mixing bowl costs Pillsbury Cakemix Company P75, and
the company estimates that customers will redeem 60 percent of the sales in units. During the
year, Pillsbury Cakemix Company purchased 20,000 mixing bowls at P75 each and 60,000 labels
were redeemed. Sales for 2015 amounted to 300,000 units at P80 each.

Required:
3. Journal entries to record the transactions.
4. Presentation of premium related transaction in the financial statements.

Solution:
3. Journal entries to record the transactions.

2015 Cash (300,000 x P80) 24,000,000

Sales 24,000,000
To record sales for the period.

- Premiums-mixing bowl (20,000 x xP75) 1,500,000

Cash 1,500,0000
To record purchase of premiums.

- Premium expense [60,000 /10 x (P75-P25)*] 300,000

Cash (60,000 /10 x P25) 150,000
Premiums-mixing bowl (60,000/10 x P75) 450,000
To record redemption of mixing bowls in the period.
 - Premium expense [120,000** /10 x (P75-P25)] 600,000
Estimated premium liability 600,000
To record claims still outstanding at the end of the period.

* The net cost of the premium is used in the computation of the premium expense because the customers
will pay P25 for each premium availed.
**The total estimated labels to be redeemed in 2015 amounted to 180,000 labels (300,000 units sold x
60%) that is equal to 18,000 premiums (180,000 labels/ 10 labels each). The redemption of 60,000 labels or
6,000 premiums (60,000 labels/ 10 labels each) brings the outstanding liability of the company as of the
end of the period to 120,000 labels or 12,000 premiums (120,000 labels/ 10 labels each).

4. Presentation of premium related transaction in the statement of financial position.

2015__
Income statement
Selling and marketing expenses:
Premium expense (P300,000 + P600,000) P900,000
Statement of Financial Position
Current assets:
Premiums- mixing bowl (P1,500,000- P450,000) P1,050,000
Current liabilities:
Estimated Premium Liability P600,000

Bonus Agreements

Many companies give a bonus to certain or all employees in addition to their regular salaries or
wages. Frequently the bonus amount depends on the company’s yearly profit. A company may
consider bonus payments to employees as additional wages and should include them as a
deduction in determining the net income for the year. It can be computed in the following ways:
Where: B = Bonus
BR = Bonus Rate
IBIT = Income Before Bonus and Before Tax
ITR = Tax Rate
IT = Income Tax

(a) Bonus is based on income before bonus and before tax.

B = BR (IBBT)
(b) Bonus is based on income after bonus and before tax.
B = BR (IBBT – B)
(c) Bonus is based on income after bonus and after tax.
B = BR (IBBT – B - IT) ; IT = TR (IBBT- B)
(d) Bonus is based on income after tax but before bonus.
B = BR (IBBT – IT) ; IT = TR (IBBT- B)
CONTINGENT LIABILITY

A contingent liability is:

(a) a possible obligation that arises from past events and 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 entity; or
(b) a present obligation that arises from past events but is not recognized because:
i. it is not probable that an outflow of resources embodying economic benefits will
be required to settle the obligation; or
ii. the amount of the obligation cannot be measured with sufficient reliability.

An entity shall not recognize a contingent liability. A contingent liability is disclosed unless the
possibility of an outflow of resources embodying economic benefits is remote.
 REVIEW QUESTIONS

1. What are liabilities?

2. What are the essential characteristics of liabilities.
3. What are the criteria in classifying liabilities as current and non-current?
4. Give at least ten (10) examples of liabilities.
5. What is a provision.
6. Differentiate estimated warranty liability and estimated premium liability.
7. What are the different assumptions under which bonus is computed?
8. What is a contingent liability?
Name : _______________________________ Score : ______________
Instructor : _______________________________ Schedule : ______________

EXERCISE 4 – 1

MULTIPLE CHOICE QUESTIONS

1. Probable future sacrifices of economic benefits arising from present obligations of a

particular entity to transfer assets or provide services to other entities as a result of past
transactions or events defines
a. Revenues c. Costs
b. Expenses d. Liabilities

2. Which is not an essential characteristic of an accounting liability?

a. The liability is the present obligation of a particular entity.
b. The payee to whom the obligation is owed must be identified.
c. The liability arises from past event or transaction.
d. The settlement of the liability requires an outflow of resources embodying economic
benefits.

3. It is an existing liability of uncertain amount or uncertain timing.

a. Contingent liability c. Discount on note payable
b. Unearned income d. Provision

4. A provision is recognized in the balance sheet when and only when

I. An enterprise has a present obligation, legal or constructive, as a result of a past event.
II. It is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation.
III. A reliable estimate can be made of the amount of the obligation.
a. I, II and III c. II and III
b. I only d. II only

5. A constructive obligation is an obligation

I. Arising from contract, legislation or operation of law.
II. That is derived from an enterprise’s action that the enterprise will accept certain
responsibilities because of past practice, published policy or current statement and as a result, the
enterprise has created a valid expectation in other parties that it will discharge those
responsibilities.
a. Both I and II c. I only
b. Neither I nor II d. II only
6. A liability shall be classified as current when it satisfies any of the following criteria (choose the
incorrect one)
a. It is expected to be settled in the entity’s normal operating cycle.
b. It is held primarily for the purpose of being traded.
c. It is due to be settled within twelve months after the balance sheet date.
d. The entity has an unconditional right to defer settlement of the liability for at least twelve
months after the balance sheet date.

7. Which can be classified as current liabilities even if they are due to be settled after more than
twelve months from balance sheet date?
a. Bank overdrafts
b. Dividends payable
c. Income taxes payable
d. Trade payables and accruals for employee and other operating costs

8. A long-term debt that is due to be settled within twelve months after the balance sheet date is
classified as noncurrent when
I. An agreement to refinance or reschedule payment on a long-term basis is completed after
balance sheet date and before the financial statements are authorized for issue.
II. The entity has the discretion to refinance or roll over the obligation for at least twelve months
after the balance sheet date under an existing loan facility.
a. I only c. Both I and II
b. II only d. Neither I nor I

9. When an entity breaches a covenant under a long-term loan agreement on or before the balance
sheet date with the effect that the liability becomes payable on demand, the liability is classified
as noncurrent when
I. The lender has agreed on or before the balance sheet date to provide a grace period ending at
least twelve months after the balance sheet date.
II. The lender has agreed after the balance sheet date and before the financial statements are
authorized for issue not to demand payment as a consequence of the breach.
a. I only c. Both I and II
b. II only d. Neither I nor II

10. Which of the following dividends are not reported as current liabilities when declared?
a. Cash dividends c. Property dividends
b. Stock dividends d. Scrip dividends