Current Liabilities, Provisions and Contingencies

Paolo Perandos Ezra Luces

Objectives
Define
Explain characteristics

Identify
Recognition criteria for liabilities Required disclosures for current liabilities and contingencies

Distinguish
Current liabilities from noncurrent liabilities Provisions from contingent liabilities

Objectives
Account
Different current liabilities after recognition

Measure
Current liabilities on the balance sheet

Definition
IASB 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.

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

What is an Obligation?
Article 1156 An obligation is a juridical necessity to give, to do or not to do.

What is an Obligation?
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.

What is an Obligating Event?

An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an entity having no realistic alternative but to settle the obligation.

Legal and Constructive Obligation

A legal obligation is one that derives from a contract, legislation or other operation of law.

Legal and Constructive Obligation

A constructive obligation is one that derives from an enterprises actions whereby:
An established pattern of past practice, published policies, or a sufficiently specific current statement,

the enterprise has indicated to other parties that it will accept certain responsibilities, the enterprise has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Settlement of Obligation
Settlement of a present obligation may occur in a number of ways, such as by
1. 2. 3. 4. Payment of cash; Transfer of assets; Provision of services; Replacement of obligation with another obligation; 5. Conversion of the obligation to equity.

Recognition of Liabilities
A liability is recorded and reported in the statement of financial position when 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.

Contingent Liability
PAS 37, paragraph 10 defines contingent liability in two ways: 1. A contingent liability is a possible obligation that arises from past event and whose existence will be confirmed only by the occurrence or non-occurrence of one ore more uncertain future events not wholly within the entity's control

Contingent Liability
2. A contingent liability is a present obligation that arises from past event but is not recognized because it is not probable that a transfer of economic benefits will be required to settle the obligation or the amount of the obligation cannot be measured reliably.

Provision
Definition: A liability of uncertain timing or amount

Provision and Contingent Liability

Provision Recognition Recognized as a liability on the face of the statement of financial position Contingent Liability Not recognized as a liability on the face of the statement of financial position

Financial statement presentation

Presented separately in the Unless remote, disclosed in statement of financial the notes to the financial position under liabilities statements

Obligations involving uncertainties are accounted as presented below:

Status
Reliably measurable Record by debiting an expense or a loss and crediting a liability

Probable
Not reliably measurable

Reasonably possible

Disclose in the notes to financial statements

Remote

Ignore (Neither recognize nor disclose)

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

Measurement of Liabilities
The amount recognized as a provision should be the best estimate of the expenditure at the end of the period, considering
Judgment of the management of the enterprise Experience of similar transactions Reports from independent experts

Measurement of Liabilities
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 balance sheet is the amount actually settled subsequently.

Measurement of Liabilities
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 is as likely as any other, the midpoint of the range is used.

Measurement of Liabilities
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.

Measurement of Liabilities
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 the 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.

Classification of Liabilities
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 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.

Examples of Current Liabilities

Accounts payable Short-term notes payable Acceptances payable Liabilities under trust receipts Deposits and advances Current portion of long-term debt Accrued liabilities Dividends payable Credit balances in customers accounts Deferred revenue Provisions expected to be settled within 12 months

Example of Non-Current Liabilities

Bonds payable Long-term deferred revenue Mortgage loans payable Long-term notes payable Liability under finance leases

Accounting for Different Current Liabilities

Accounts Payable Discounts
1. Trade Discounts
Example: 10%
Accounts Payable Cash Accounts Payable Cash 90 90 100 100

2. Cash Discounts
Example: 3/10; n/30 Gross Method Net Method

3. Progressive Discounts
Example: 5:10:15

Accounts Payable Cash

72.68 72.68

Accounting for Different Current Liabilities

Gross Method
Purchases and accounts payable accounts are recorded at gross invoice price A cash discount taken on purchases is recorded upon payment as Purchase Discounts Any balance of Purchase Discounts is reported in profit or loss as a deduction from gross purchases

Accounting for Different Current Liabilities

Net Method
Purchases and accounts payable are initially recorded at invoice price less the cash discounts available. A cash discount not taken is recorded as Purchase Discounts Lost, which is reported in profit or loss as part of finance cost

Accounting for Different Current Liabilities

Example Assume that Ezer Steroids Corporation purchased merchandise from Perandos Loves KFC Company with an invoice price of 200,000: terms FOB shipping point, 3/10; n/30 The purchase took place on Nov. 2, 2013. Perandos Loves KFC Company prepaid the freight charges of 2,000. Ezer Steroids Corporation paid the full account on Nov. 10, 2013. Assume further that Ezer Steroids Corporation uses periodic inventory system. Entries in the books of Ezer Steroids Corporation to record the purchase and payment under the gross and net methods are:

Accounting for Different Current Liabilities

Nov. 2, 2013 date of purchase
Gross method: Net method:

Purchases 200,000 Freight in 2,000 Accounts Payable 202,000

Purchases 194,000 Freight in 2,000 Accounts Payable 196,000

Accounting for Different Current Liabilities

Nov. 10, 2013 date of account settled
Gross Method: Net Method:

Accounts Payable 202,000 Purchase Discount 6,000 Accounts Payable 196,000

Accounts Payable Cash

196,000

196,000

Accounting for Different Current Liabilities

If the account is paid beyond the discount period, the journal entry for the payment would be: Gross Method: Net Method:

Accounts Payable Cash

202,000 202,000

Accounts Payable 196,000 Purchase Discounts Lost 6,000 Cash 202,000

Note that the 3% cash discount is based on the cost of goods purchased, not including freight cost

Accounting for Different Current Liabilities

Notes Payable 1. Interest bearing
a. Realistic interest b. Unrealistic interest

2. Non-Interest Bearing

Accounting for Different Current Liabilities

Note Bearing a Realistic Interest Rate
Assume the issuance of such note is in settlement of an overdue trade account
Accounts Payable Notes Payable xxx xxx

At maturity:
Notes Payable Interest Expense Cash xxx xxx
xxx

Accounting for Different Current Liabilities

Note Bearing a Realistic Interest Rate
At the end of the reporting period (if the note is still outstanding)
Interest Expense xxx Interest Payable xxx

Accounting for Different Current Liabilities

Note Bearing an Unrealistic Interest Rate When do we say that the note bears an unrealistic interest rate?
When the rate on face of the note is significantly different from the market rate of similar notes; or When the consideration received on account of the note issued has a fair value which is significantly different from the face of the note.

Accounting for Different Current Liabilities

Note Bearing an Unrealistic Interest Rate In such cases, the note and the interest to be paid based on the stated rate are discount at the market rate of interest on the date of the issuance.

Accounting for Different Current Liabilities

Note Bearing an Unrealistic Interest Rate If stated rate > market rate = premium If market > stated rate = discount

Accounting for Different Current Liabilities

Note Bearing an Unrealistic Interest Rate Example Stated Rate of Note is more than the market rate: May 1, 2013, Ezer Chickser Corporation purchased from Chickser Ezer Corporation by issuing a 14%, one-year note for 320,000. Market rate of interest on similar notes is 8%.

Accounting for Different Current Liabilities

Note Bearing an Unrealistic Interest Rate The present value is computed as follows:

Accounting for Different Current Liabilities

Note Bearing an Unrealistic Interest Rate The following are the entries in 2013 related to the note:
2013 May 1

Equipment 337,768 Notes Payable 320,000 Premium on Notes Payable 17,768

Interest Expense Premium on Notes Payable Interest Payable 18,014 11,853 29,867

Dec 31

Accounting for Different Current Liabilities

Note Bearing an Unrealistic Interest Rate Assume no reversing entries were made at Jan 1, 2014, the following entries are made:
2014 May 1 Premium on Notes Payable Interest Expense 5,915 5,915

May 1

Notes Payable Interest Payable Interest Expense Cash

320,000 29,867 14,933

364,800

Accounting for Different Current Liabilities

Non-Interest Bearing Note The present value of the non-interest bearing is the amount of: 1. Cash received, or fair value of goods and services rendered. 2. Prevailing market rate of interest for a similar obligation.

Accounting for Different Current Liabilities

Non-Interest Bearing Note The discounted amount should be used to initially record the liability. The notes payable account is credited equal to the face value of the note and a corresponding debit is made to the account discount on notes payable.
Equipment Discount on Notes Payable Cash Notes Payable xxx xxx xxx xxx

Accounting for Different Current Liabilities

Non-Interest Bearing Note The net credit account (NP less discount on NP) is the initial amortized cost of the liability. Interest expense is then recognized over the term of the note, using effective interest method, as an adjustment of this discounted amount.

Accounting for Different Current Liabilities

Non-Interest Bearing Note This is done by charging interest expense and crediting discount on notes payable

Interest Expense Discount on Notes Payable

xxx xxx

Accounting for Different Current Liabilities

Non-Interest Bearing Note Example Assume the following information: On October 1, 2013 Ezer Chickser Corporation purchased an equipment, paying 100,000 down and issuing a oneyear, non-interest-bearing note for 200,000. There is no known market value for the equipment. The prevailing market rate of interest for similar transactions at that time is 12%.

Accounting for Different Current Liabilities

Non-Interest Bearing Note The cost of equipment is 278,571, computed as follows:

Accounting for Different Current Liabilities

Non-Interest Bearing Note The initial discount on Notes Payable is 21,429 computed as follows:
Face value of the note 100,000 Present value at the date of issuance 178,571 Discount on Notes Payable 21,429

Accounting for Different Current Liabilities

Non-Interest Bearing Note The transaction on October 1, 2013 is recorded as:
Equipment Discount on Notes Payable Cash Notes Payable 278,571 21,429 100,000 200,000

Accounting for Different Current Liabilities

Non-Interest Bearing Note On December 31, 2013, an adjusting entry is made as follows:

Accounting for Different Current Liabilities

Non-Interest Bearing Note Upon payment of the note on October 1, 2014:
Interest Expense Discount on Notes Payable Notes Payable Cash 16,072 16,072 200,000 200,000

Accrued Liabilities
Accrued liabilities consists of obligations for expenses incurred on or before the end of the reporting period but payable at a later date. Accrued liabilities include those payables to specific persons and determinable with reasonable accuracy. They also include provisions. Common examples of liabilities of this nature are accrued salaries, accrued interests, accrued rentals and accrued taxes. An accrued liability is taken up as an adjustment at year-end by charging an expense account and crediting an accrued liability account.
Utilities Expense Utilities Payable xxx xxx

Premiums
Premiums: articles of value such as toys, dishes, silverware and other goods and in some cases cash payments, given to customers as result of past sales or sales promotion activities.

 In order to stimulate the sale of their products, entities offer premiums to customers in return for product labels, box tops, wrappers and coupons. Accordingly, when merchandise is sold an accounting liability for future distribution of premium arises and should be given accounting recognition

To illustrate, assume that Perandos Piglet Inc. launched a new sales promotional program. For every 10 product box tops returned to the company, customers receive an attractive prize. Perandos Piglet Inc. estimates that only 60% of the product box tops reaching the consumer will be redeemed.

 Additional information as follows:

Units Sale of products (in boxes) Purchase of premiums (prizes) Premiums distributed to customers 2,000,000 100,000 82,000 800,000 Amount P90,000,000

 Cash(or AR) Sales

(sales of products)

90,000,000 90,000,000

Premium Inventory 800,000 Cash(or AP) 800,000

(purchase of premiums)

Premium Expense 656,000 Premium Inventory 656,000 (82,000 x 8)

-(Redemption of pemiums) Premium Expense 304,000 Estimated Premium Claims Outstanding 304,000
(Year-end adjustment for outstanding premiums)

{(2,000,000 x 60%)/10} 82,000 = 38,000 x P8 = 304,000

Product and service warranties

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

 Accordingly, at the point of sale an obligation arises and a liability is incurred. To illustrate the accounting for warranties, consider the following data: Perandos Piglet Inc. sells DVD and VCD systems with a two-year warranty. The company estimates warranty costs as a percentage of peso sales as follows: 1st year 3%; 2nd year 8%

 Sales and Actual repairs for 2011 and 2012 are: Sales: 2011 P2,500,000; 2012- P4,750,000 Actual warranty repairs: 2011 P53,000; 2012- P184,500 Entries: 2011 Warranty Expense 275,000 Liability for Warranty 275,000 Liability for Warranty 53,000 Cash, etc. 53,000 Warranty Expense for 2011: 11%xP2,500,000

2012 Warranty Expense 522,500 Liability for Warranty 522,500

Liability for Warranty 53,000 Cash, etc. 53,000 Warranty Expense for 2012: 11%xP4,750,000 = 522,500

Customer Loyalty Prorgam

Entities use a customer loyalty program to build brand loyalty, retain their valuable customers and of course, increase sales volume. The customer loyalty program is generally designed to reward customers for past purchases and provide tem with incentives to make further purchases.

 If a customer buys goods or services, the entity grants the customer award credits often described as points The entity can redeem the points by distributing to the customer free or discounted goods or services. A customer loyalty program operates in a variety of ways. Customers may be required to accumulate a specified minimum number of award credits or points before they can be redeemed.

 The entity supplies the awards itself: Consideration allocated to the award credits is recognized as deferred revenue. Revenue is recognized when the award credits are redeemed.

 To illustrate, assume the Perandos Piglet Inc. grants to its customers 2 reward points for each P100 sales. Each point is redeemable in the form of merchandise and equivalent to P1. The points accumulate and may be used by the customer as part payment for merchandise purchases in the future. During the month of April 2012, total sales of the company amounted to P24,000,000

 Fair values of merchandise and the reward points are P23,520,000 and P480,000 respectively. Entries: Cash 24,000,000 Sales 23,520,000 Liability for Customer Loyalty 480,000

By the end of the first year, 40% of the points have been redeemed, and it is expected that only a total of 90% of the points granted will be redeemed by the customers. Perandos Piglet Inc. recognizes revenue for points redeemed at P213,333 (wchis is 40%/90% x 480,000) The entry for the redemption is: Liability for Customers Loyalty Awards 213,333 Sales 213,333

 Third party supplies the award If the entity is collecting the consideration as principal in the transaction, the amount of revenue is equal to the gross consideration to the award credits. If the entity is collecting the consideration as agent of the third party, the amount revenue is equal to the net amount retained on its own account

 For example, assume that Perandos Piglet Inc. participates in a customer loyalty programme operated by Ezer Steroids Co. It grants Perandos Piglet Inc. privelege cardholders one point for every P50 spent on bacon. Cardholders can redeem the points for reduction in selling prices of steroids to be bought at Ezer Steroids Co. Thus, Perandos Piglet Inc. upon sale of baco to customers, records the full amount of the consideration received as sales and recognizes an expense for points expected to be redeemed by customers of Ezer Steroids Inc.

 Books of Perandos Piglet Inc. Upon sale of bacon Cash xxx sales xxx Upon redemption of points Premium Expense xxx Payable to Ezer xxx

Books of Ezer Steroids Co. No entry

AR-Perandos Cash(if any) Sales

Dividends Payable
Cash dividend payable is an amount owed by a corporation to its shareholders as a result of board of directors action on the distribution of corporate earnings in the form of cash. It is recorded as a current liability upon declaration.

Dividends in arrears are not recognized as liabilities because there is no obligating event. They are simply disclosed in the notes to financial statements A share dividend distributable , is not classified as liability in the balance sheet because it will not require outflow from the enterprises resources, it is merely an additional issuance of shares.

Deposits and advances

Deposits and advances consist of cash or property received which are returnable to the depositor and are to be remitted to third parties. If the deposit or advance results from the companys operating activities )e.g., containers from San Miguel Beer, Coca-cola and Pepsi Cola are sold on returnable containers.)

 The liability is normally reported as current. But if the deposit is nontrade and expected to be refunded or paid after one year, the liability is reported as non-current.

 To illustrate accounting for deposits and returnable containers, assume the information presented bellow: Balance of Deposits for returnable containers, 1/1/12 Deposits received for containers sold Deposits refunded Deposits forfeited for containers not returned Cost of containers not returned Accum depreciation on containers not returned

P250,000 800,000 720,000

60,000 55,000 15,000

 The entries for the foregoing transactions: Cash 800,000 Customer Deposits for Returnable Containers 800,000 Customer Deposits on Returnable Containers 720,000 Cash 720,000

 Customer Deposits on Returnable Containers 60,000 Accum. Depreciation 15,000 Returnab Containers Gain on Sale of Returnable Containers

55,000 20,000

 The resulting balance reported as Deposits on Returnable Containers in the above illustration is 270,000 computed as follows: (P250,000 + 800,000 720,000 60,000)

Unearned revenues
Unearned revenues are amounts collected in advance hat have not ye been earned and recorded as revenues pending completion of the earning process. These are collections in advance for interest, rent, magazine subscriptions, royalties, tickets, tokens, gifts certificates and service contracts.

 Treatment for unearned revenues are either based on liability method or income method. Under the income method, the entry for advance collection of revenue is Cash Revenue xxx xxx