CHAPTER 1 LIABILITIES TECHNICAL KNOWLEDGE To understand the concept of liabilities. To define current and noncurrent liabilities. To know the measurement of current and noncurrent liabilities. To explain the treatment of long-term debt falling due within one year. To explain the treatment of breach of covenants attached to a long-term debt. To describe formulas in computing bonus to officers and employees.LIABILITIES The Revised Conceptual Framework for Financial Reporting provides the following definition of liabilities: Liabilities are present obligations of an entity to transfer an economic resource as a result of past events. Accordingly, the essential characteristics of an accounting liability are: a. The entity has a present obligation. An obligation is a duty or responsibility that an entity has no practical ability to avoid. The entity liable must be identified but it is not necessary that the payee to whom the obligation is owed be identified. b. The obligation is to transfer an economic resource. This is the very heart of the definition of an accounting liability. The economic resource is the asset that represents a right with a potential to produce economic benefit. Specifically, the obligation must be to pay cash, transfer noncash asset or provide service at some future time. c. The liability arises from a past event. This means that the liability is not recognized until it is incurred. Present obligation An essential characteristic of a liability is that the entity has a present obligation. The present obligation may be a legal obligation or a constructive obligation. An obligation may be legally enforceable as a consequence of binding contract or statutory requirement. This is normally the case, for example, with accounts payable for goods and services received. A constructive obligation also gives rise to liability by reason of normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. 2Transfer of an economic resource Without payment of money, without transfer of noncash asset, without performance of service, there is no accounting liability. A crystallization of the definitive concept of an accounting liability is when an entity declares cash dividend. In such a case, there is an obligation to pay cash, hence, accounting liability exists. But when an entity declares share dividend, there is no accounting liability. The obligation is to issue the entity's own shares. The issuance of the entity’s own shares is not a transfer of noncash asset because the share capital is an equity item. Thus, share dividend payable is classified as part of equity rather than an accounting liability. Past event Another essential characteristic of a liability is that the liability must arise from a past transaction or event. The past event that leads to a legal or constructive obligation is known as the obligating event. The obligating event creates a present obligation because the entity has no realistic alternative but to settle the obligation created by the event. For example, the acquisition of goods gives rise to accounts payable. The obligating event is the acquisition of goods. The receipt of a bank loan results in an obligation to repay the loan. The obligating event is the cash received from the bank as a consequence of the bank loan. An entity signed a contract to performsservices the following year. At the end of current year, there is no accounting liability because only a contract has been signed, There is no past event that substantiates the liability. There is no future obligation to provide services because neither party has executed the contract.Current liabilities PAS 1, paragraph 69, as amended provides that an entity shall classify a liability as current when: a. The entity expects to settle the liability within the entity's operating cycle. b. The entity holds the liability primarily for the purpose of trading. c. The liability is due to be settled within twelve months after the reporting period. d. The entity does not have the right at the end of the reporting period to defer settlement of the liability for at least twelve months after the reporting period. Trade payables and accruals for employee and other operating costs are part of the working capital used in the entity's normal operating cycle. Such operating items are classified as current liabilities even if settled more than twelve months after the reporting period. In other words, trade payables and accruals for operating costs are classified as current when due within one year or the operating cycle, whichever is longer. When the entity's normal operating cycle is not clearly identifiable, its duration is assumed to be twelve months. Other current liabilities are not settled as part of the normal operating cycle but are due for settlement within twelve months after the reporting period or held primarily for the purpose of trading. Such other current liabilities include financial liabilities held for trading, bank overdraft, dividends payable, income tax payable, other nontrade payables due within one year and current portion of noncurrent financial liabilities. Financial liabilitiés held for trading are financial liabilities that are incurred with an intention to repurchase them in the near term. An example is a quoted debt instrument that the issuer may buy back in the near term depending on changes in fair value. 4Specific examples of current 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 ce. 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. Income tax payable g. Deferred or unearned revenue realizable within one year Measurement of current liabilities Conceptually, all liabilities are initially measured at present value and subsequently measured at amortized cost. However, in practice, current liabilities or short-term obligations are not discounted anymore but measured and reported at face amount. The reason is that the discount or the difference between the face amount and the present value of the liability is usually not material and therefore ignored, Noncurrent liabilities The term noncurrent liabilities is a residual definition. All liabilities not classified as-current are classified as noncurrent liabilities. Specific examples of noncurrent liabilities include: a. Noncurrent portion of long-term debt such as notes, mortgages, bonds and finance lease liability b. Deferred tax liability c. Long-term obligation to officers d. Long-term deferred revenue Measurement of noncurrent liabilities Noncurrent liabilities, for example, bonds payable and noninterest-bearing note payable, are initially measured at present value and subsequently measured at amortized cost. If the long-term note payable is interest-bearing, it is initially and subsequently measured at face amount. In this case, the face amount is equal to the present value of the note payable. The amortized cost measurement is taken up in a later chapter in relation to bonds payable.Presentation of current liabilities Under Paragraph 54 of PAS 1, as a minimum, the face of the statement of financial position shall include the following line items for current liabilities: a. Trade and other payables b. Current provisions c. Short-term borrowing d. Current portion of long-term debt e. Current tax liability The term 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. Estimated liabilities Estimated liabilities are obligations which exist at the end of reporting period although their amount is not definite. In many cases, the date when the obligation is due is not also definite and in some instances, the exact payee cannot be identified or determined. But inspite of these circumstances, the existence of the estimated liabilities is valid and unquestioned. Deferred revenue Deferred revenue or unearned revenue is income already received but not yet earned. Deferred revenue may be realizable within one year or in more than one year after the end of the reporting period. If the deferred revenue is realizable within one year, it is a current liability. Typical examples of current deferred revenue are unearned interest income, unearned rental income and unearned subscription revenue. If the deferred revenue is realizable in more than one year, it is classified as noncurrent liability. Typical examples of noncurrent deferred revenue are unearned revenue from long-term service contracts and long-term leasehold advances. 6Long-term debt falling due within. one year A liability due to be settled within twelve months after the reporting period is classified as current, even if: a. The original term was for a period longer than twelve months. by 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. However, 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. As amended, if the entity has the right at the end of the reporting period to roll over an obligation for at least twelve months after the reporting period under an existing loan facility, the obligation is classified as noncurrent even if it would otherwise be due within a shorter period. The right to defer settlement for at least twelve months after the reporting period must exist at the end of the reporting period. If the right does not exist at the end of the reporting period, there is no potential to refinance and therefore the liability is classified as current. For example, the end of reporting period is Decenber 31, 2024. An obligation that matures on June 30, 2025 is classified as current liability even if it is refinanced on a long-term basis on January 31, 2025 before the issuance of the 2024 financial statements on March 31, 2025. However, if the obligation is refinanced on a long-term basis on December 31, 2024, end at the reporting period, it is classified as noncurrent liability. Moreover, if the entity has an existing right to defer settlement of the obligation for at. least twelve months after December 31, 2024, the obligation is classified as noncurrent liability even if there is no refinancing. aCovenants Covenants are often attached to borrowing agreements which represent undertakings by the borrower. Covenants are actually restrictions on the borrower such as undertaking further borrowings, paying dividends, maintaining specified level of working capital and so forth. Under these covenants, if certain conditions are breached at the end of reporting period, the liability becomes payable on demand. The IASB amended the requirements for classification of noncurrent liabilities with covenants. The IASB concluded that only covenants that an entity must comply on or before the end of reporting period will affect the classification as current or noncurrent., In other words, if an entity has already complied with the covenants at the reporting date, the liability is classified as noncurrent. Otherwise, the liability is classified as current if the covenant is not complied with at the reporting date. Covenants that must be complied with after the end of reporting period do not affect the classification of the liability as current or noncurrent at the end of current reporting period. However, an entity shall disclose information about noncurrent liabilities subject to future covenants. For example, on January 1, 2024, an entity had a loan outstanding that is payable on December 31, 2029. The loan included a covenant requiring a working capital ratio at least 1.5 on December 31, 2024 and at least 1.8 on July 1, 2025. When the entity prepared its financial statements on December 31, 2024, the working capital ratio is 1.6. The entity expected its working capital ratio to be 1.7 on July 1, 2025. The loan is classified as noncurrent on December 31, 2024 because the covenant was complied with on such date. The ratio on December 31, 2024 is below the covenant on July 1, 2025. However, this will not affect the classification of the liability as noncurrent on December 31, 2024 with respect to the future covenant that must be complied with on July 1, 2025, after thevend of the reporting period. The expectation of a working capital ratio of 1.7 on July 1, 2025 will not affect the classification on December 31, 2024. 8Bonus computation Large entities often compensate key officers and employees by way of bonus for superior income realized during the year. The main purpose of this scheme is to motivate officers and employees by directly relating their well-being to the success of the entity. The bonus compensation plan results in lability that must be measured and reported in the financial statements. Four variations of bonus computation 1. Bonus is expressed as a certain percent of income before bonus and before tax. 2. Bonus is expressed as a certain percent of income after bonus but before tax. 3. Bonus is expressed as a certain percent of income after bonus and after tax. 4. Bonus is expressed as a certain percent of income after tax but before Lonus. Illustration Income before bonus and before tax 4,400,000 Bonus 10% Income tax rate 25% Case 1 - Before bonus and before tax Income before bonus and before tax 4,400,000 Multiply by 10% Bonus 440,000Case 2 - After bonus but before tax B = .10 (4,400,000 — B) B = 440,000 —.10B B+.10B = 440,000 1.10B = 440,000 B = 440,000/1.10 B = 400,000 Proof Income before bonus and before tax 4,400,000 Bonus (400,000) Income after bonus but before tax 4,000,000 Multiply by 10% Bonus 400,000 Case 3 - After bonus and 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 + .25B) B 440,000 - .10B — 110,000 + .025B B+.10B - .025B = 440,000-110,000 330,000 330,000 / 1.075 306,977 -25 (4,400,000 — 306,977) 1,028,255 Proof Income before bonus and before tax 4,400,000 Bonus (_ 306,977) Tax (1,023,255) Income after bonus and after tax 8,069,768 Multiply by 10% Bonus 306,977 10Case 4 — After tax but before bonus B = .10 (4,400,000 - T) T = .25 (4,400,000 - B) B = .10 [4,400,000 - .25 (4,400,000 — B)] B = .10 (4,400,000 - 1,100,000 + .25B) B = 440,000 — 110,000 + .025B B - .025B = 440,000 - 110,000 .975B: = 330,000 B = 330,000/.975 B = 338,462 Proof Income before bonus and before tax 4,400,000 Tax (4,400,000 — 338,462 x 25%) (1,015,384) Income after tax but before bonus 3,384,616 Multiply by 10% Bonus 338,462 11PROBLEMS Problem 1-1 (AICPA Adapted) Gar Company reported the following liability account balances on December 311, 2024: Accounts payable 1,900,000 Bonds payable, due December 31, 2026 3,400,000 Discount on bonds payable 200,000 Deferred tax liability 400,000 Dividends payable 500,000 Income tax payable 900,000 Note payable, due December 31, 2025 600,000 On December 31, 2024, what total amount should be reported as current liabilities? a. 7,100,000 b. 4,300,000 c. 8,900,000 d. 3,300,000 Problem 1-2 (AICPA Adapted) Brite Company provided the following information on December 31, 2024: Accounts payable 550,000 Note payable, 8% unsecured, due July 1, 2026 4,000,000 Accrued expenses 350,000 Contingent liability 450,000 Deferred tax liability 250,000 Bonds payable, 7%, due December 31, 2025 5,000,000 Premium on bonds payable 500,000 The contingent liability is an accrual for possible loss on a P1,000,000 lawsuit filed against the entity. The legal counsel expected the suit to be settled in 2025 and estimated that the entity shall be liable for damages in the range of P450,000 to P750,000. What total amount should be reported as current liabilities on December 31, 2024? a. 4,900,000 b. 5,350,000 c. 6,400,000 d. 6,850,000 13Problem 1-3 (IAA) Burma Company disclosed the following information about liabilities at year-end: Accounts payable, after deducting debit balances in suppliers’ accounts amounting to P100,000 4,000,000 Accrued expenses 1,500,000 Credit balances of customers’ accounts 500,000 Share dividend payable 1,000,000 Claims for increase in wages and allowance by employees of the entity, covered ina pending lawsuit 400,000 Estimated expenses in redeeming prize coupons presented by customers 600,000 What total amount should be reported as current liabilities at year-end? a. b. 6, c. 7,100,000 d. 7,700,000 Problem 1-4 (IAA) Manchester Company provided the following information on December 31, 2024: Income taxes withheld from employees 900,000 Cash balance at First State Bank 2,500,000 Cash overdraft at Harbor Bank 1,300,000 Accounts receivable with credit balance 750,000 Estimated expenses of meeting warranties on merchandise previously sold 500,000 Estimated damages as a result of unsatisfactory performance on a contract 1,500,000 Accounts payable 3,000,000 Deferred serial bonds, issued at par and bearing interest at 12%, payable in semiannual installment of P500,000 due April 1 and October 1 of each year, the last bond to be paid on October 1, 2030. Interestis also paid semiannually. 5,000,000 Share dividend payable 2,000,000 What amount should be reported as current liabilities on December 31, 2024? a. 7,950,000 b. 8,100,000 c. 8,600,000 d. 8,450,000 14Problem 1-5 (AICPA Adapted) Achilles Company reported the following liability balances on December 31, 2024: ae note te Payable inex issued on March 1, 2023, maturing Marc 5,000,000 10% note payable Seued on October 1, 2023, maturing October 1, 2025 3,000,000 On January 31, 2025, the entire P5,000,000 balance of the 12% note payable was refinanced through issuance of a long-term obligation payable lump sum. On December 31, 2024, the entity has the right to defer settlement of the 10% note payable for at least twelve months after December 31, 2024. The 2024 financial statements were issued on March 31, 2025. What amount of the notes payable should be classified as current on December 31, 2024? a. 8,000,000 b. 5,000,000 c 8,000,000 d. 0 Problem 1-6 (AICPA Adapted) Eliot Company reported the following liablities on December 31, 2024: Accounts payable 1,000,000 1236 note payable issued November 1, 2028 maturing July 1, 2025 2,000,000 10% note payable issued October 1, 2023 maturing October 1, 2025 1,400,000 10% debentures payable, next annual principal installment of P500,000 due February 1, 2025 7,000,000 On December 31, 2024, the entity consummated a noneancelable agreement with the lender to refinance the 12% note payable on a long-term basis. On December 81, 2024, the entity has the right to roll over the 10% note payable for at least twelve months after the end of reporting period. What total amount should be reported as current liabilities on December 31, 2024? a. 2,900,000 b: 3,000,000 ¢. 1,500,000 d. 2,500,000 15