Current Liabilities,

Provision and Contingencies

Group 2

Liabilities
The Framework for the Preparation and Presentation of Financial
Statements provide the following definition of liabilities:

Liabilities are 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.

Measurement of liabilities
PAS 39 provides that an entity shall recognize initially a financial liability
at:
Fair value plus transaction costs that are directly attributable to the
issue of the financial liability.
After initial recognition, an entity shall measure a financial liability at
amortized cost.

Measurement of liabilities
Fair value of the liability = present value of the future cash payment
to settle the obligation.
The term present value is the discounted amount of the future cash
outflow in settling an obligation using the market rate of interest.
Accordingly, all liabilities are measured at present value or discounted
amount.

Measurement of current liabilities

Current liabilities or short term obligations are not
discounted anymore but measured, recorded and
reported at their face amount.

Classification of Liabilities
Under PAS 1 on presentation of financial statements, liabilities
are classified into two namely:
a. Current liabilities
b. Noncurrent liabilities

Current Liabilities
PAS 1, paragraph 69, provides that an entity shall classify a liability as
current when:
a. The entity expects to settle the liability within the entitys 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 an unconditional right to defer settlement
of the liability for at least twelve months after the reporting period.

Current Liabilities
Trade payables and accruals for employee and other operating costs
are part of the working capital used in the entitys normal operating
cycle.
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.

Current Liabilities
Examples of such current liabilities are financial liabilities held for
trading, bank overdraft, dividends payable, income taxes, other
nontrade payables and current portion of noncurrent financial liabilities
Financial liabilities held for trading are financial liabilities that are
incurred with an intention to repurchase them in the near term.

Long-term debt falling due within one year

A liability which is 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
b. An agreement to refinance or to reschedule payment on a longterm basis is completed after the reporting period and before the
financial statements are authorized for issue

Long-term debt falling due within one year

NOTE:
If the refinancing or rolling over is not at the discretion
of the entity, the obligation is classified as current
liability.

Covenants
Covenants - restrictions on the borrower as to
undertaking further borrowings, paying
dividends, maintaining specified level of working
capital and so forth.

Breach of covenants
If certain conditions relating to the borrowers financial
situation are breached, the liability becomes payable on
demand.
PAS 1 provides that such a liability is classified as current if the
lender has agreed, after the reporting period and before the
settlements are authorized for issue, not to demand payment
as a consequence of the breach.

Breach of covenants
This liability is classified as current because at the end
of the reporting period, the entity does not have an
unconditional right to defer its settlement for at least
twelve months after that date.

Nonadjusting events
The following events occurring between the end of the reporting period and the
date the financial statements are authorized for issue shall qualify for disclosure
as nonadjusting events:
1. Refinancing on a long-term basis
2. Rectification of a breach of a long-term loan agreement
3. The granting by the lender of a grace period to rectify a breach of a longterm loan arrangement ending at least twelve months after the reporting
period.

Presentation of current liabilities

a.
b.
c.
d.
e.

Trade and other payables

Current provisions
Short-term borrowing
Current portion of long-term debt
Current tax liability

Presentation of current liabilities

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.
An entity shall present additional line items on the face
of the statement of financial position when such
presentation is relevant to an understanding of the
entitys financial position

Estimated liabilities
Estimated liabilities are obligations which exist at the end
of the reporting period although their amount is not
definite.
Estimated liabilities are either current or noncurrent in
nature. Examples include estimated liability for premium
and warranties.
Under PAS 37, an estimated liability is considered as a
provision which is both probable and measurable.

Estimated premium liability

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

Accounting procedures for the acquisition of premiums and

recognition of the premium liability are as follows:

1. When the premiums are purchased:

Premiums

xx

Cash

xx

2. When the premiums are distributed to customers:

Premium expense

xx

Premiums

xx

3. At the end of the year, if premiums are still outstanding:

Premium expense
Estimated premium liability

xx
xx

ILLUSTRATION

An entity manufactures a certain product and sells it at P 300 per unit. A soup bowl is
offered to customers on the return of P5 wrappers plus a remittance of P10. The bowl costs
P50, and it is estimated that 60% of the wrappers will be redeemed.
The data for the first year concerning the premium plan are summarized below.
Sales, 10,000 units at P300 each
Soup bowls purchased, 2,000 units at P50 each
Wrappers redeemed

1. To record the sales:

Cash
Sales
2. To record the purchase of premiums:
Premiums soup bowls
Cash

3,000,000
100,000
4,000

3,000,000
3,000,000
100,000
100,000

3. To record the redemption of 4,000 wrappers:

Cash (800 x 10)
8,000
Premium expense (800 x 40)
32, 000
Premiums soup bowls (800x50)

40,000

(4,000 wrappers/5 = 800 bowls distributed)

4. To record the liability for the premiums at the end of the first year:
Premium expense
16,000
Estimated premium liability
16,000
Wrappers to be redeemed (60% x 10,000 wrappers)
Less: Wrappers redeemed
Balance
Premiums to be distributed (2,000 / 5)
Estimated liability (400 x 40)

6,000
4,000
2,000
400
16,000

Financial statement classification

At the end of the year, the accounts related to the premium plan
are classified as follows:
Current asset:
Premiums soup bowls
Current liability:
Estimated premium liability
Selling expense:
Premium expense

60,000

16,000

48,000

Estimated warranty cost

Home appliances like television sets, stereo sets, ratio sets,
refrigerators and the like are often sold under guarantee or warranty
to provide free repair service or replacement during a specified
period if the products are defective
Such entity policy may involve significant costs on the part of the
entity if the products sold prove to be defective in the future within
the specified period of time. Accordingly, at the point of sale, a
liability is incurred.
Two approaches followed: accrual approach and expense as
incurred approach.

Accrual approach
The accrual approach has the soundest theoretical support because it
properly matches cost with revenue.
Following this approach, the estimated warranty cost is recorded as follows:

Warranty expense
Estimated warranty liability

xx
xx

When actual warranty cost is subsequently incurred and paid, the entry is:
Estimated warranty liability
Cash

xx
xx

At a certain date, the estimate is reviewed to determine its reasonableness and

accuracy. The actual warranty cost is analyzed to validate the original estimate.

Any difference between estimate and actual cost is a change in estimate and
therefore treated currently and prospectively, if necessary. Thus, if the actual
cost exceeds the estimate, the difference is charged to warranty expense as
follows:

Warrant expense
Estimated warranty liability

xx
xx

The subsequent payment of the warranty cost is then charged to the estimated
liability account.
If the actual cost is less than the estimate, the difference is an adjustment to
warranty expense as follows:

Estimated warranty liability

Warranty expense

xx
xx

ILLUSTRATION
Television Company sells 1,000 units of television sets at P9,000 each for cash. Each television
set is under warranty for one year and the entity has estimated from past experience that
warranty cost will probably average P500 per unit and that only 60% of the units sold will be
returned for repair. The entity incurs P180,000 for repairs during the year.

The pertinent entries are:

1. To record the sales:
Cash
9,000,000
Sales
2. To set up the estimated liability on the warranty:
Warranty expense
300,000
Estimated warranty liability

9,000,000

300,000

Estimated sets to be returned for repair (60% x 1,000 sets)

Multiply by estimated warranty cost per set
Estimated warranty cost

600 sets
500
300,000

3. To record the payment of the actual cost:

Estimated warranty liability
180,000
Cash
180,000
The statement of financial position at the end of the year would report
estimated warranty liability of P120,000 as a current liability, and the income
statement for the year would show warranty expense of P300,000.
If the warranty runs over a period of more than one year, a portion of the
estimated warranty liability shall be reported as current liability and the
remaining portion as noncurrent liability. In other words, the warranty cost
expected to be incurred within one year is classified as current and the
balance as noncurrent.

Expense as incurred approach

The expense as incurred approach is the approach of expensing warranty cost only
when actually incurred. This is popular in practice because it is the one recognized
for income tax purposes and frequently justified on the basis of expediency when
warranty cost is not very substantial or when the warranty period is relatively short.

Thus, in the preceding example, the actual warranty cost of P180,000 is simply
recorded as follows:
Warranty expense

180,000

Cash
180,000

Gift certificates payable

Many megamalls, department stores, and supermarkets sell gift
certificates which are redeemable in merchandise. The
accounting procedure are:
1. When the gift certificates are sold:
Cash
xx
Gift certificates payable
xx
The latter account is a current liability

Gift certificates payable

2. When the gift certificates are redeemed:
Gift certificates payable
xx
Sales
xx
3. When the gifts certificates expire:
Gift certificates payable
xx
Forfeited gift certificates
xx
The forfeited gift certificates account is classified other income.

Refundable deposits
Refundable deposits consist of cash or property
received from customers but which are refundable
after compliance with certain conditions
Example: customer deposit required for returnable
containers like bottles, drums, tanks and barrels.

ILLUSTRATION
1. A deposit of 10,000 is required from the customer for returnable containers. The containers
cost P8,000.
Cash
Containers deposit

10,000

10,000

The containers deposit account is usually classified as current liability.

2. Assume the customer returns the containers
Containers deposit
10,000
Cash
10,000
3. Assume the customer fails to return the containers.
Containers deposit
10,000
Containers
8,000
Gain on sale of containers
2,000

Deferred Revenue
Deferred revenue or unearned revenue is income already received
but not yet earned. Deferred revenue may be realizable within one
year on in more than one year from 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.

PROVISION AND CONTINGENT LIABILITY

Definition of provision
A provision is an existing liability of uncertain timing or
uncertain amount. The essence of a provision is that
there is uncertainty about the timing or amount of the
future expenditure.
Actually, a provision may be the equivalent of an
estimated liability or a loss contingency that is accrued
because it is both probable and measurable.

Provision and other liabilities

In contrast, there is certainty about the timing or amount of other liabilities,
such as trade payables and accruals.
Trade payables are liabilities to pay for goods or services that have been
received or supplied and have been invoiced or formally agreed with the
supplier.
Accruals are liabilities to pay for goods or services that have been received or
supplied but have not been paid, invoiced or formally agreed with the
supplier, including amounts due to employees.

Recognition of provision
PAS 37 states that a provision shall be recognized as a liability in the
financial statements under the following conditions:
a. The entity has a present obligation, legal or constructive, as a result
of past event.
b. It is probable that an outflow of resources embodying economic
benefits would be required to settle the obligation.
c. The amount of the obligation can be measured reliably.

Present obligation
A Legal obligation is an obligation arising from a contract, legislation,
or other operation of law.
A constructive obligation is an obligation that is derived from an
entitys actions where:
a. The entity has indicated to other parties that it will accept certain responsibilities by
reason of an established pattern of past practice, published policy, or a sufficiently
specific current statement.
b. b. And as a result, the entity has created a valid expectation on the part of other
parties that it will discharge those responsibilities.

Past event
An obligating event is an event that creates a legal or constructive
obligation because the entity has no realistic alternative but to settle
the obligation created by the event. This is the case where:
a. The settlement of the obligation can be enforced by law.
b. The event ( which may be an action of the entity) creates valid
expectations on the part of other parties that the entity will
discharge the obligation, as in the case of a constructive obligation.

Probable outflow of economic benefits

An outflow of resources is regarded as a probable if
the event is more likely that not to occur, meaning,
the probability that the event will occur is greater
than the probability that it will not occur. As a rule of
thumb, probable means more than 50% likely.

Reliable estimate
PAS 37 suggests that by using a range of possible outcomes,
an entity usually would be able to make an estimate of the
obligation that is sufficiently reliable.
Where no reliable estimate can be made, no liability is
recognized.

Measurement of provision
The amount recognized as a provision should be the best estimate of
the expenditure required to settle the present obligation at the end of
reporting period.
The best estimate is the amount that an entity would rationally pay to
settle the obligation at the end of the reporting period or to transfer
it to a third party at that time
The estimates of outcome are determined by the judgement of
management of an entity supplemented by experience similar
transactions, and reports from independent experts.

Measurement of provision
Where there us 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 provision is being measured involves a large population of
items, the obligation is estimated by weighting all possible
outcomes by their associated possibilities. The name for this
statistical method of estimation is expected value.

ILLUSTRATION expected value method

An entity sells good with a warranty under which customers are covered for the cost
of repairs of any manufacturing defects that become apparent within 6 months after
purchase.
If minor defects are detected in all products sold, repair costs would be about
P1,000,000. If major defects are detected in all products sold, repair costs of P5,000,000
would result.
The entity past experience and future expectations indicate that 75% of the goods
sold will have no defects, 20% will have minor defects and 5% will have major defects.

The expected value or cost of repairs is measured as follows:

75% sales
20% sales (20% x 1,000,000)
5% sales (5% x 5,000,000)

None
200,000
250,000

Total expected value or cost of repairs

450,000

Other measurements considerations

The following items are taken into consideration in recognizing and
measuring a provision:
1. Risks and uncertainties
6. Changes in provision
2. Present value of obligation
7. Use of provision
3. Future events
8. Future
operating loses
4. Expected disposal of assets
9. Onerous contract
5. Reimbursements

Risks and uncertainties

Risk describes variability of outcome. A risk adjustment may increase
the amount at which a liability is measured.
As prudence dictates, caution is needed in making judgement under
conditions of uncertainty so that income and assets are not
overstated, or expenses and liabilities are not understated.
However, uncertainty does not justify the creation of excessive
provision or a deliberate overstatement of liabilities.

Present value of obligation

Where the effect of time value of money is material, the amount of
provision shall be the present value of the expenditure expected to
settle the obligation.
The discount rate should be pretax rate that reflects the current
market assessment of the time value of money and the risk specific to
the liability.
The discount rate should not reflect the risk for which cash flow
estimates have already been adjusted.

Future events
Future events that affect the amount required to
settle an obligation shall be reflected in the amount of
provision where there is sufficient evidence that they
will occur.
Such future events include new legislation and
changes in technology.

Expected disposal of asset

Gains from expected disposal of asset shall not be taken into account
in measuring a provision.
Instead, an entity shall recognize gain on disposal at the time of the
disposition of the assets.
In other words, any cash inflows from disposal are treated separately
from the measurement of the provision.

Reimbursements
Where some or all of the expenditure required to settle a provision is expected to be
reimbursed by another party, the reimbursement shall be recognized when it is
virtually certain that reimbursement would be received if the entity settles the
obligation.

The reimbursement shall be treated as a separate asset and not netted against the
estimated liability for the provision. The amount of provision shall not exceed the
amount of the provision.
However, in the income statement, the expense relating to the provision may be
presented net of the reimbursement.

Changes in provision
Provisions shall be reviewed at every end of the reporting period and
adjusted to reflect the current best estimate.
The provision shall be reversed if it is no longer probable that an
outflow of economic benefits would be required to settle the
obligation.
Where discount is used, the carrying amount of the provision
increases each period to reflect the passage of time.

Use of provision
A provision shall be used only for expenditures for which the
provision was originally recognized
Setting expenditures against a provision which was originally
recognized for another purpose would conceal the impact of
two different events.

Future operating losses

Provision shall not be recognized for future operating losses.
A provision for operating losses is not recognized because a past
event creating a present obligation has not occurred.
However, an expectation of future operating losses is an indication
that certain assets may be impaired. An impairment test for these
assets may be necessary.

Onerous contract
If an entity has an onerous contract, the present obligation under
the contract shall be recognized and measured as a provision.
An onerous contract is a contract in which the unavoidable costs
of meeting the obligation under the contract exceed the
economic benefits expected to be received under it.

Contingent liability
PAS 37 defines a contingent liability in two ways:
1. A possible obligation that arises from past event and whose
existence will be confirmed only by the occurrence or
nonoccurrence of one or more uncertain future events not wholly
within the control of the entity.
2. A present obligation that arises from past event but is not
recognized because it is not probable that an outflow of resources
embodying economic benefits will be required to settle the
obligation or the amount of the obligation cannot be measure
reliably.

Examples of provision
Warranties the best estimate of the warranty cost is recognized as a
provision because in this case there is a clear legal obligation arising from an
obligating event which is the sale of the product with warranty.
Environmental contamination
Decommissioning or abandonment costs
Court case
Guarantee

Contingent liability and provision

The present obligation is either probable or measurable but
not both to be considered a contingent liability.
If the present obligation is probable and the amount can be
measured reliably, the obligation is not a contingent liability
but shall be recognized as a provision.

Treatment of contingent liability

A contingent liability shall not be recognized in the financial statements but
shall be disclosed only. The required disclosures are:
a. Brief description of the nature of the contingent liability.
b. An estimate of its financial effects
c. An indication of the uncertainties that exist.
d. Possibility of an reimbursement.
If a contingent liability is remote, no disclosure is necessary.