LIABILITIES

Intermediate Accounting 2
Reference: Zeus Vernon B. Millan
(2109). Intermediate Accounting 2
What is a LIABILITY?

LIABILITY is a present obligation of the entity to transfer

an economic resource as a result of past event
The definition of liability has the following three aspects:
a. Obligation
b. Transfer of an economic resource
c. Present obligation as a result of past events
Types of OBLIGATION

a. Legal obligation – an obligation that results

from a contract, legislation, or other operation of
law; or
b. Constructive obligation – an obligation that
results from an entity’s actions (e.g. past practice
or published policies) that create a valid
expectation on others that the entity will accept
and discharge certain responsibilities.
Types of OBLIGATION

a. Legal obligation – an obligation that results

from a contract, legislation, or other operation of
law; or
b. Constructive obligation – an obligation that
results from an entity’s actions (e.g. past practice
or published policies) that create a valid
expectation on others that the entity will accept
and discharge certain responsibilities.
OBLIGATION

▪ An obligation is always owed to another party.

However, it is not necessary that the entity of that
party is known, for example, an obligation for
environmental damages may be owed to the society at
large.
• One party’s obligation normally corresponds to another
party’s right.
OBLIGATION Example

▪ A buyer’s obligation to pay an account payable of P100 normally

corresponds to the seller’s right to collect accounts receivable of P100.
However, this accounting symmetry is not maintained at all times
because the standards sometimes contain different recognition and
measurement requirements for the liability of one party and the
corresponding asset of the other party.
▪ For example, direct origination costs result to different measurements of
the lender’s loan receivable and the borrower’s loan payable. Similarly, a
seller may be required to recognize a warranty obligation but the buyer
would not recognize a corresponding asset for that warranty.
Uncertain Liabilities

•There can be instances where the existence

of an obligation is uncertain. Until that
uncertainty is resolved (for example, by a
court ruling), it is uncertain whether a
liability exists.
Uncertain Liabilities

•There can be instances where the existence

of an obligation is uncertain. Until that
uncertainty is resolved (for example, by a
court ruling), it is uncertain whether a
liability exists.
Transfer of an Economic resource
▪ The liability is the obligation that has the potential to require
the transfer of an economic resource to another party and not
the future economic benefits that the obligation may cause to
be transferred.
▪ Thus, the obligation’s potential to cause a transfer of
economic benefits need not be certain, or even likely, for
example, the transfer may be required only if a specified
uncertain future event occurs.
▪ What is important is that the obligation already exists and
that, in at least one circumstance, it would require the entity
to transfer an economic resource.
Transfer of an Economic resource

▪ Consequently, a liability can exist even if the

probability of a transfer of an economic resource
is low, although that low probability affects
decisions on whether the liability is to be
recognized, how it is measured, what information
is to be provided about the liability, and how that
information is provided.
Transfer of an Economic resource

An obligation to transfer an economic resource may be an

obligation to:
a. Pay cash, deliver goods, or render services;
b. Exchange assets with another party on unfavorable terms;
c. Transfer assets if a specified uncertain future event occurs; or
d. Issue a financial instrument that obliges the entity to transfer
an economic resource.
Present obligation as a
result of past events
The obligation must be a present obligation that exists as
a result of past events. A present obligation exists as a
result of past events if:
a. The entity has already obtained economic benefits or
taken an action; and
b. As a consequence, the entity will or may have to
transfer an economic resource that it would not
otherwise have had to transfer.
Present obligation as a
result of past events
Examples:
Entity A intends to acquire goods in the future.

Analysis:
Entity A has no present obligation. A present obligation arises
only when Entity A:
a. Has already purchased and received the goods; and
b. As a consequence, Entity A will have to pay for the purchase
price.
Present obligation as a
result of past events
▪ Entity B operates a nuclear power plant. In the current year,
a new law was enacted penalizing the improper disposal of
toxic waste. No similar law existed in prior years.

Analysis:
The enactment of legislation is not in itself sufficient to result
in an entity’s present obligation, except when the entity:
a. Has already taken an action contrary to the provisions of that
law; and
As a consequence, the entity will have to pay for a penalty.
Present obligation as a
result of past events
Accordingly:
- Entity B has no present obligation if its existing method of
waste disposal does not violate the new law. Similarly, Entity B
has no present obligation if it can avoid penalty by changing its
future method of waste disposal.

- On the other hand, Entity B has a present obligation if its

previous waste disposal has already caused damages, and as a
consequence, Entity B has to pay for those damages.
Present obligation as a
result of past events
▪ Entity C enters into an irrevocable commitment with another party to
acquire goods in the future, on credit.
Analysis:
A non-cancellable future commitment gives rise to a present obligation
only when it becomes onerous (i.e., burdensome), for example, if the
goods become obsolete before the delivery but Entity C cannot cancel
the contract without paying a substantial penalty.
Unless it becomes burdensome, no present obligation normally arises
from a future commitment.
 Present obligation as a
result of past events
▪ Although not stated in the sales contract, Entity D has a
publicly-known policy of providing free repair services for the goods
it sells. Entity D has consistently honored this implied policy in the
past.
Analysis:
Entity D has a present constructive obligation to provide free repair
services for the goods it has already sold because:
a. Entity D has already taken an action by creating valid expectations
on the customers that it will provide free repair services; and
b. As a consequence, Entity D will have to provide those free services.
Present obligation as a
result of past events
▪ Entity E obtained a loan from a bank. Repayment of
the loan is due in 10-years’ time.
Analysis:
Entity E has a present obligation because it has
already received the loan proceeds, and as a
consequence, has to make the repayment, even
though the bank cannot enforce the repayment until a
future date.
Present obligation as a
result of past events
▪ Entity F has caused environment damages. Although, no law exists
penalizing such act, Entity F believes it has an obligation to rectify
the damages. However, the identity of the party to whom the
obligation is owed cannot be specifically identified.

Analysis:
Entity F has a present obligation because it has already caused the
damages, and as a consequence, has to rectify the damages, even it
the identity of the party to whom the obligation is owed is not
specifically known.
Present obligation as a
result of past events
Entity G employed Mr. Juan.
Analysis:

Entity G has no present obligation until after M. Juan has

rendered services. Before the, the contract is executory –
Entity G has a combined right and obligation to exchange
future salary for Mr. Juan’s future services.
EXECUTORY CONTRACTS
▪ An executory contract “ is a contract that is equally unperformed –
neither party has fulfilled any of its obligations, or both parties have
partially fulfilled their obligations to an equal extent.”
▪ An executory contract establishes a combined right and obligation to
exchange economic resources, which are interdependent and
inseparable.
▪ Thus, the two constitute a single asset or liability. The entity has an
asset if the terms are unfavorable. However, whether such an asset
or liability is included in the financial statements depends on the
recognition criteria and the selected measurement basis, including
any assessment of whether the contract is onerous.
EXECUTORY CONTRACTS
▪ The contract ceases to be executory when one party
performs its obligation.
▪ If the entity performs first, the entity’s combined right and
obligation changes to an asset.
▪ If the other party perform first, the entity’s combined right
and obligation changes to an asset.
▪ If the other party performs first, the entity’s combined right
and obligation changes to a liability.
EXECUTORY CONTRACTS
Continuing the previous example:
- Entity G neither recognizes an asset nor a liability upon entering the
employment contract with Mr. Juan because, at that point, the
contract is executory.
- If Mr. Juan rendered services, the contract ceases to be executory,
and Entity G’s combined right and obligation changes to a liability –
an obligation to pay Mr. Juan’s salary (e.g. salaries payable).
- If Entity G pays Mr. Juan’s salary in advance, Entity G’s combined
right and obligation changes to an asset – a right to receive the
services or a right to be reimbursed if the services are not received (
e.g., advances to employees).
 Recognition Criteria
An item is recognized if:
a. It meets the definition of a liability; and
b. Recognizing it would provide useful information, i.e., relevant and faithfully
represented information.

Both the criteria above must be met before an item is recognized. Accordingly,
items that meet the definition of a liability but do not provide useful
information are not recognized, and vice versa. However, even if a liability is
not recognized, information about it may still need to be disclosed in the
notes, In such cases, the item is referred to as unrecognize liability.
 RELEVANCE
Recognition may not provide relevant information, if for example:
a. It is uncertain whether a liability exists; or
b. A liability exists, but the probability of an outflow of economic
benefits is low

Existence uncertainty or low probability of an outflow of economic

benefits may result in, but does not automatically lead to, the
non-recognition of a liability. Other factors should be considered.
FAITHFUL
REPRESENTATION
▪ A liability must be measured for it to be recognized. Often
measurement requires estimation and thus subject to measurement
uncertainty.
▪ The use of reasonable estimates is an essential part of financial
reporting and does not necessarily undermine the usefulness of
information.
FAITHFUL
REPRESENTATION
▪ Even a high level of measurement uncertainty does not necessarily
preclude an estimate from providing useful information if the
estimate is clearly and accurately described and explained.
▪ However, an exceptionally high measurement uncertainty does not
necessarily preclude an estimate from providing useful information if
the estimate is clearly and accurately described and explained.
▪ However, an exceptionally high measurement uncertainty can affect
the faithful representation of a liability.