INTER2 MODULE 1 LIABILITIES

LEARNING OBJECTIVES ;

Students are expected to comprehend the following ;

1. The requirements for the existence of a liability

2. The different types of liabilities
3. The classification of liabilities into current and non current amount
4. The computation of accrued interest payable

INTRODUCTION TO LIABILITIES ;

In layman’s term , liabilities are considered to arise from the borrowing of funds by an entity or by a
person. However in accounting, liabilities arise not just from borrowing of funds but also from many
other sources , as long as the criteria for the recognition of liability are met.

According to the conceptual framework , a liability is a present obligation of the entity to transfer an
economic resource as a result of past events .

All of the following criteria shall b e met for a liability to exist ;

a. The entity has an obligation

b. The obligation is to transfer an economic resource
c. The obligation is a present obligation that exists as a result of past events

OBLIGATION

An obligation is a duty or responsibility which an entity has no practical ability to avoid. An obligation
may arise from any of the following ;

a. Contract, laws and regulations known as legal obligation

b. An entity’s customary practices, published policies or specific statements with an entity
having no practical ability to avoid

It is not required to specifically recognize the identity of the counter party for an obligation to exist.
For example, estimated warranty liability will still be recognized even though an entity does not know
who of its customers will ultimately claim its right under the warranty.

In addition, an obligation exists even if the exact amount of the obligation is unknown , provided that
it can be reliably estimated . Using warranties again as an example , related liability is recognized even
though its amount is based solely on a reliable estimate.

OBLIGATION TO TRANSFER AN ECONOMIC RESOURCE

Obligations to transfer an economic resource include, for example

a. An obligation to pay cash – for accounts payable to suppliers , accrued expenses and
borrowings .( ex. Loan and bond payables )
 b. Obligations to deliver goods or provide services – for income received in advance or provision
of warranty coverage
c. Obligations to exchange economic resources with another party on unfavorable terms - for
derivative liabilities
d. Obligations to transfer an economic resource if a specified uncertain future events occurs – for
conditional obligations

PRESENT OBLIGATION AS A RESULT OF PAST EVENTS

There shall be a present obligation as a result of past events for an entity to recognize a liability.
Obligation that will be incurred in the future shall not be recognized as there is no present obligation
to account for.

A good exam[le of future obligation is when an entity orders an item of equipment . On the date the
equipment was ordered , no obligation shall be recognized since the equipment is yet to be delivered
to the entity. It is only when the equipment was delivered to the entity that a liability is recognized
since there is already a past event .

A present obligation exists as a result of past events only if

a. The entity has already obtained economic benefits or taken an action

b. As a consequence , the entity will or may have to transfer an economic resource that it would
not otherwise have had to transfer

The following are examples of ways an entity obtains economic benefits and the resulting obligation

a. An entity acquiring inventory will recognize a corresponding amount of liability ( ex. Accounts
payable ) if it has already taken title over the goods
b. Utilities ( ex. Electricity or water ) provide an entity economic benefit as they are consumed .
Because of these consumed utilities, an entity will now be required to pay a corresponding
amount to the utilities provider (accrued expenses )

GENERAL CLASSIFICATION OF LIABILITIES

For accounting purposes , liabilities can be broadly classified into financial and non financial liabilities

FINANCIAL LIABILITIES – is any liability that give rise to a contractual obligation

a. To deliver cash or another financial asset to another entity

b. To exchange financial assets or financial liabilities with another entity under conditions that
are potentially unfavorable to the entity

The following are examples of liabilities that are considered as financial liabilities

a. Accounts and trade payables

b. Notes payable
c. Bonds and loans payable
d. Derivatives liability
 The following are considered as non financial liabilities
a. Unearned income (income received in advance ) the obligation of the entity is deliver
goods or provide services to customers rather than delivering cash or another financial
asset
b. Estimated warranty liability – the obligation is to provide service to correct the defects or
malfunctions of products previously sold
c. Income tax payable , deferred tax payable and other tax liabilities – the obligation does
not arise from contracts but rather as a statutory requirement
d. Constructive obligations – the obligation does not arise from contracts but from the
expectations of relevant parties

It should be noted that certain liabilities such as lease liabilities and employee benefits appear to be
financial liabilities, but these are accounted differently. (different accounting standards ) rom the rest
of the true financial liabilities .

ACCOUNTING FOR FINANCIAL LIABILITIES

Generally, according to PFRS 9 , financial liabilities are initially measured at their fair value less the
transaction costs incurred . Subsequently, financial liabilities are generally measured at their
amortized cost .

The accounting for amortized cost is similar to investments at amortized cost. The point of view is now
on the issue rather than the investor’s point of view .

As a way of exception, an entity on initial recognition may irrevocably designate a financial liability at
fair value through profit or loss . (FVTPL) and recognize changes in the liability’s fair value in profit or
loss . This alternative is normally applicable to bonds payable as their fair value are reliably
determinable .

ACCOUNTING FOR NON FINANCIAL LIABILITIES

For non financial liabilities , different accounting procedures are followed depending on the relevant
accounting standard that applies . For example

a. Provisions are accounted for under PAS 37 Provisions , contingent liabilities and contingent
assets
b. Lease liabilities are accounted for under PFRS 16 , leases
c. Liabilities for employee benefits are accounted for under PAS 19 . Employees benefits

Other non financial liabilities are measured in the following manner

a. Estimated amount to be incurred or paid to the counter parties ( ex. Warranties payable,
advances from customers , unearned income, liability from gift certificates )

FINANCIAL REPORTING OF LIABILITIES

Generally, in the entity’s statement of financial position , liabilities are classified as either current or
non current
An entity shall classify a liability as current when ;

a. It expects to settle the liability as current when

b. It holds the liability within its normal operating cycle
c. The liability is due to be settled within 12 months after the reporting period
d. It does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting period

An entity shall classify all other liabilities as non current PAS 1.69

It should be noted that any of these criteria is enough to classify a liability as current.

CRITERION 1 – It expects to settle the liability within its normal operating cycle . The operating
cycle of an entity is the time between the acquisition of assets for processing and their
realization in cash or cash equivalents .
When the entity’s normal operating cycle is not clearly identifiable , it is assumed to be 12
months
This criterion is made for trade payables such as the following ;
a. Accounts payable
b. Notes payable for operating purposes
c. Accrued operating expenses
d. Unearned income
e. Warranty liabilities

These are normally classified as current even if they will be settled beyond 12 months after
the reporting date as long as it will be paid within the normal operating cycle .

For an example , an accounts payable that is due to be paid in 15 months is still considered as
current if the entity’s normal operating cycle is 18 months .

CRITERION 2 HOLDS THE LIABILITY PRIMARILY FOR THE PURPOSE OF TRADING

A liability is considered as held for trading if

a. It is acquired for the purpose of selling or repurchasing it in the near term.

b. On initial recognition is part of a portfolio of identified financial instruments whereby
there is evidence of recent actual pattern of short term profit taking
c. Derivative (except those designated and effective hedging instrument )

Under this criterion, and in the absence of additional information financial liabilities at FVTPL are
usually classified as current. The reason for this is that, in the absence of contrary information , the
financial liabilities at FVTPL are assumed to be held for trading . Prime example of this is the derivative
liability.

However , financial liability at FVTPL , that was irrevocably designated as such on initial recognition is
not necessarily considered as current mainly because it may not be held for trading .
CRITERION 3 THE LIABILITY IS DUE TO BE SETTLED WITHIN 12 MONTHS AFTER THE REPORTING
PERIOD

This criterion covers non trade liabilities such as

a. Bank overdraft
b. Dividends payable
c. Current and deferred income taxes and indirect taxes
d. Notes payable issued other than for operating expenses
e. Loans and bonds payable (including accrued interest )
f. Lease liability
g. Premium liability

In the absence of additional information, bonds payable, mortgage payable and pension
liabilities are normally classified as non current liabilities .
For these liabilities to be considered as current , they must be settled within 12 months after
the reporting date, regardless of the original term of the liability.

Applying this principle , the following non trade payables are current
a. Bank overdraft and dividends payable
b. Current income tax payable and indirect taxes payable
c. Accrued interest payable
d. Notes, loans and bonds payable maturing within 12 months after the reporting
date ,regardless of the length of their original term
e. Portion of notes payable , loans payable , bonds payable and lease liability that are due to
be settled within 12 months after the reporting date .

However, deferred tax liability is always considered as non current .

EXAMPLE ; ROSE COMPANY had the following non trade payable as at December 31, 2023

7 year bonds payable with maturity of July 1, 2024 4,000,000

3 year bonds payable with maturity of December 31, 2025 2,000,000

5 year loan payable borrowed last October 1, 2019 5,000.000

4 year loan payable borrowed last April 1, 2022 1,000,000

10 year loan payable borrowed last June 30, 2023 , principal is

Payable in 10 equal annual installments starting June 30,2024 10,000,000

6 year loan payable with 400,000 semi annual principal payments every

January 1 and July 1 of each year 8,000,000

Accrued interest payable 625,000

Required ; From these given liabilities , determine the amounts to be classified as current and non
current .
SOLUTIONS ;

CURRENT NON CURRENT

7 year bonds payable 4,000,000

3 year bonds payable 2,000,000

5 year bonds payable 5,000,000

4 year loans payable 1,000,000

10 year loan payable 1,000,000 9,000,000

6 year loan payable 800,000 7,200,000

Accrued interest payable 625,000

Totals 11,425,000 19,200,000

CRITERION 4

It does not have an unconditional right to defer settlement of the liability for at least 12 months after
the reporting period/date .

A liability that is due to be settled within 12 months is normally classified as current , in the absence of
both of the following

a. Unconditional right of an entity to defer the settlement of the liability

b. The deferment is at least 12 months after the reporting date

The unconditional right of an entity can also mean sole discretion of the entity which means that a
borrowing entity may make a decision without needing for an agreement with the other parties.

Deferment means extending the maturity date beyond the original one . If the entity has the sole
discretion to extend the maturity date, the period of extension shall also be considered in classifying
the liability as current or non current. This deferment is also known as refinancing .

EXAMPLE 2

As of December 31, 2023 , DAVID Company had a loan payable maturing on June 30, 2024. The
Company has the sole discretion to extend the maturity date up to June 30, 2025 .

Based on this information, the loan payable shall be classified as non current since it has an
unconditional right to defer the settlement for at least 12 months after December 31, 2023 . This is
regardless of the loan’s original maturity date of June 30, 2024 , which is just six months after
December 31, 2023 .

EXAMPLE 3
Going back to David Company , except that the maturity date may be extended to June 30, 2025 ,
provided the lender will agree

Based on the revised information, the loans payable shall still be classified as current as the company
does not have unconditional right to defer the settlement . This is because the agreement with the
lender is needed to extend the maturity date to June 30, 2025 .

EXAMPLE 4

At the end pf 2023, CRUZ COMPANY had a bond payable maturing on April 1, 2024 . The company has
the sole discretion to extend the maturity date up to October 1, 2024 .

The bond payable shall still be classified as current. There is an unconditional right to defer the
maturity date, but the deferred maturity date of October 1, 2024 is still less than twelve months from
December 31, 2023. This only shows that it is also important to consider the length of deferment in
addition to assessing whether there is an unconditional right to defer.

CONVERTIBLE BONDS PAYABLE

Some bonds may be converted into equity securities of the issuer. Despite this feature , it shall not be
considered in classifying bonds payable as current or non current . Instead criterion 3 shall be applied
by assessing the period from the reporting date to maturity date .

EXAMPLE 5

As of the end of 2023, Tongol Company had the following convertible bonds payable

10 year bonds payable maturing on September 30,2024 7,000,000

5 year bond payable maturing on April 1, 2027 2.000.000

In this case, the convertibility feature of each bond payable shall be ignored . The 10 year bonds
payable shall be classified as current since its maturity date is nine months after December 31, 2023 .
On the other hand , the 5 year bond payable shall be classified as non current since its maturity date is
more than 12 months after December 31, 2023.

LIABILITIES – BREACH OF COVENANTS AND GRACE PERIOD

Loans payable and bonds payable normally contain covenants that contain restrictions and or
condition that the borrower is required to follow . The purpose of these covenants is to highly
discourage the borrower from doing activities that may diminish its ability to pay the liability.

If this covenants were breached , the related liabilities will now become current , regardless of the
liability’s remaining term before maturity .

However, despite the breach , the creditor may decide to give the borrower a grace period, where the
creditor will temporarily not demand the immediate payment and will allow the borrower to rectify
the restrictions and or conditions breached.

However , even if the grace period has been granted after the reporting date , it shall be disclosed in
the financial statements .
EXAMPLE 6

DAVID COMPANY had a loan payable as of December 31, 2023, with remaining period to maturity of 5
years . One of the loan’s covenants is for the Company to maintain a current ratio of 3.0 at all times .
However , as of the same date the current ratio was 2.7 which is below the minimum ratio.

Because of the breach of covenant, the loan payable shall be classified as current regardless of the 4
year remaining maturity in the absence of any grace period .

EXAMPLE 7

At the beginning of 2022, TANGLAO company borrowed a loan payable that will mature on December
31, 2027. Included in the loan’s covenant is the timely payment of monthly interest. As of December
31, 2023 , the company is 5 months behind paying interest. As a result of this breach, the loan and the
related accrued interest became immediately due and demandable even it will originally mature on
December 31, 2027.

Required ;

Under each of the following independent scenarios , determine the classification of the loan (current
or non current ) as of December 31, 2023

1. A grace period not to demand payment for the next 18 months was granted on December 20,
2023
2. A grace period not to demand payment for the next 18 months was granted on January 10,
2024
3. A grace period not to demand payment for the next 6 months was granted on December 24,
2023

Answers;

Scenario 1

The loan shall be classified as non current since the grace period was given before December 31, 2023
and there is deferral of payment for more than 12 months after the same date .

Scenario 2

The loan shall still be classified as current since the grace period was only given after December 31,
2023 , regardless of the period of deferral of payment . however the granting of the grace period shall
be disclosed in the 2023 financial statements .

Scenario 3

The loan shall still be classified as current since the length of the grace period will still require
payment 6 months after December 31, 2023 .

LIABILITIES PAYABLE ON DEMAND

Liabilities , which the creditor can declare as due and demandable anytime , are always classified as
current . This is regardless of the liability’s remaining term until its maturity date.

EXAMPLE 8

On December 31, 2023 , ASTRO COMPANY reported a loan payable with maturity date of December
31, 2026 . The creditor can demand the payment of the loan anytime, even before the maturity date .

In this case the loan shall be classified as current , regardless of its remaining term of three years.

ACCRUED INTEREST PAYABLE

The computation of accrued interest payable is similar in the computation of accrued interest
receivable from notes receivable . It should be recalled that interest is earned incurred in the passage
of time . The general formula in computing accrued interest is as follows;

INTEREST = PRINCIPAL X STATED RATE X TIME

When using this formula, the readers should take note of the following ;

a. Principal amount to be used is at the beginning of the interest period

b. Time to be used is from the immediately preceding interest payment date up to the reporting
date. The frequency of interest payment (annually, semi annually, quarterly) will affect the
amount of accrued interest
c. If one of the interest payment dates is every December 31 , accrued interest as of December
31 of each year will be zero
d. Assuming all other things are constant, the more frequent that the interest is paid , the lower
the amount of accrued interest as of the reporting date .

EXAMPLE 9

AS of December 31, 2023 , LAUS COMPANY had the following outstanding interest bearing liabilities ;

1. 10 year loan payable dated April 1. 2021 with face amount of 5,000,000 and interest of 8
percent . The interest is payable annually every March 31 of each year.

Payment date 3/31/23

Latest IPD to 12/31/23 9 MONTHS

Accrued interest payable 12/31/23 300,000 ( 5m x 8 % x 9/12 )

2. 5 year, 12 percent interest bearing bond payable dated June 1, 2022 with face amount of
3,000,000 interest is payable every MAY 31 and November 30 of each year .

PD 11/30/23
LATEST IPD TO 12/31/23 1 MONTH
ACCRUED INTEREST PAYABLE 30,000 ( 3M X 12 % X 1/12 )
 3. 6 year 9 % interest bearing loan payable dated JANUARY 1, 2021 with face amount of
2,000,000 . interest is payable every December 31 of each year.

PD 12/31/23

LATEST IPD TO 0 MONTHS

ACCRUEID INTEREST PAYABLE 0 (2M X9 %X 0/12 )

NOTES;

1. Accrued interest payable is normally classified as part of current liabilities ,

2. There is no accrued interest payable for liability 3 since the interest payable date is every
dec. 31 of each year. For this liability, interest expense for each year is always fully paid as
of each reporting date .

OTHER ITEMS TO BE CONSIDERED ;

1. The accounts payable shall be reported gross of debit balances in the suppliers accounts. The
debit balances shall be separately reported as advances to suppliers (asset account ) The
following is the pro forma entry for reclassification if the accounts payable is net of these
amounts .
Advances to suppliers xx
Accounts payable xx

2. The credit balances in the customers accounts shall be reported as part of current liabilities (in
the unearned income account ) The following is the pro forma entry for reclassification if the
accounts receivable is net these amounts .
Accounts receivable xxx
Unearned income xxx

3. The amount of bank overdraft that cannot be offset with the other bank account balances
shall be classified as part of current liabilities. The following is the pro forma entry for
reclassification if the cash in bank is already net of this amount.

Cash in bank xx

Bank overdraft (liability ) xx