Liabilities, Provisions, and Contingencies PDF

BM2403 LIABILITIES, PROVISIONS, AND CONTINGENCIES NATURE AND RECOGNITION OF LIABILITIES The IAS 37/PAS 37 Provisions, Contingent Liabilities, and Contingent Assets defines liab...

BM2403 LIABILITIES, PROVISIONS, AND CONTINGENCIES NATURE AND RECOGNITION OF LIABILITIES The IAS 37/PAS 37 Provisions, Contingent Liabilities, and Contingent Assets defines liability as “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of company’s resources embodying economic benefits.” Based on the definition, a liability possesses the following essential characteristics: 1. Present obligation - An obligation is a duty or responsibility that an entity cannot avoid in any practical way. The entity liable must be recognized, but the payee to whom the obligation is payable does not have to be identified. 2. Past event states liability originates from a past event or transaction. This past event is commonly known as an obligating event. This event puts an entity in a position to settle the present obligation with no alternative courses of action. 3. Outflow of future economic benefits - This states that all accounting liability requires the payment of money, non-cash assets, or the performance of a certain service. Initial Recognition of Financial Liabilities PFRS 9 Financial Instruments provides that an entity shall measure a financial liability at its fair value, plus or minus, in the case of a financial liability not at fair value through profit or loss. These transaction costs are attributable to the issue of financial liability. In theory, all liabilities are initially measured at present value and then at amortized cost. However, current liabilities or short-term obligations are measured and reported at face value rather than discounted. As a result, only the non-current liabilities, such as bonds payable and long-term notes payable, are initially measured at present value and subsequently measured at amortized cost. If the note payable is interest-bearing, it is initially and subsequently measured at face value. Subsequent Measurement of Financial Liabilities As discussed above, current liabilities are subsequently measured at face value, while non-current liabilities are subsequently measured at amortized cost. “Subsequent measurement” pertains to recording a particular account’s value at every balance sheet date. CLASSIFICATION OF LIABILITIES PAS 1 Presentation of Financial Statements provides two (2) liability classifications: current and non- current. “Presentation” pertains to how the financial statement accounts are arranged depending on the classification used by the company. Current Liabilities As discussed in PAS 1, an entity shall classify a liability as current when (International Financial Reporting Standards, 2001): It expects to settle the liability in its normal operating cycle; It holds the liability primarily for trading; The liability is due to be settled within 12 months after the reporting period or 01 Handout 1 *Property of STI  [email protected] Page 1 of 8  BM2403 It does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. Some current liabilities, such as trade payables, some accruals for employees, and other operating costs, are part of the working capital used in the entity’s normal operating cycle. An entity classifies such operating items as current liabilities even if they are due to be settled more than 12 months after the reporting period. The same normal operating cycle applies to classifying an entity’s assets and liabilities. When the entity’s normal operating cycle is not identifiable, it is assumed to be 12 months (International Financial Reporting Standards, 2001). Other current liabilities are not settled as part of the normal operating cycle but are due for settlement within 12 months after the reporting period or held primarily for trading. Examples of these liabilities are as follows (International Financial Reporting Standards, 2001): Financial liabilities that meet the definition of held for trading; Bank overdrafts; Current portion of non-current financial liabilities; Dividends payable; Income taxes, and Other non-trade payables. Financial liabilities that provide financing on a long-term basis (i.e., not part of the working capital used in the entity’s normal operating cycle) and due for settlement beyond 12 months after the reporting period are non-current liabilities (International Financial Reporting Standards, 2001). Non-Current Liabilities All other liabilities not qualified for recognition under current liability shall be classified as non-current. Non-current liabilities include (Valix, Peralta, & Valix, 2023): Non-current portion of long-term debt; Finance lease liability; Deferred tax liability; Long-term obligation to entity officers; and Long-term deferred revenue. Rules on Classifying Long-Term Debt Due Within 12 Months After the Reporting Period An entity classifies its financial liabilities as current when they are due to be settled within 12 months after the reporting period, even if (International Financial Reporting Standards, 2001): The original term was for a period longer than 12 months, and An agreement to refinance or to reschedule payments on a long-term basis is completed after the reporting period and before the financial statements are authorized for issue. Suppose an entity expects and has the discretion to refinance or roll over an obligation for at least 12 months after the reporting period under an existing loan facility. In that case, it classifies the obligation as non-current, even if it would otherwise be due within a shorter period. However, when refinancing or rolling over the obligation is not at the entity's discretion (e.g., no arrangement for refinancing), the entity does not consider the potential to refinance the obligation. It classifies the obligation as current (International Financial Reporting Standards, 2001). 01 Handout 1 *Property of STI  [email protected] Page 2 of 8  BM2403 Rules on Breaches of Provision in a Long-Term Loan Arrangement As discussed in PAS 1, paragraph 74, when an entity breaches a provision of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand, it classifies the liability as current, even if the lender agreed, after the reporting period and before the authorization of the financial statements for issue, not to demand payment as a consequence of the breach. An entity classifies the liability as current as the entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. However, an entity classifies the liability as non-current if the lender agrees by the end of the reporting period to provide a grace period ending at least 12 months after the reporting period, within which the entity can rectify the breach and during which the lender cannot demand immediate repayment (International Financial Reporting Standards, 2001). ACCOUNTING FOR PROVISIONS A provision is an account maintained by an entity to cover an expected liability even though the amount and timing are uncertain. The uncertainty in provision is the salient feature that distinguishes it from the other types of liabilities. Provision is not a form of savings; it is the repository for the upcoming outflow of economic resources. Provisions, being considered a liability, require some essential characteristics for its recognition. As stated in PAS 37, a provision shall be recognized when (International Financial Reporting Standards, 2001): a. An entity has a present obligation (legal or constructive) as a result of a past event; b. An outflow of resources embodying economic benefits will probably be required to settle the obligation and c. A reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognized. In rare cases, it is unclear whether there is a present obligation. In those cases, a past event is deemed sufficient to give rise to a present obligation if, taking account of all evidence, it is more likely that a present obligation exists at the end of the reporting period. For example, whether certain events have occurred or resulted in a present obligation may be disputed in a lawsuit. An entity determines the recourse for this action by taking legal advice from a lawyer. (International Financial Reporting Standards, 2001). Based on such evidence, the following are the rules for recognition: Chance of Present Classification Accounting Treatment Obligation to Exist More likely than not Provision (if recognition Recognize by debiting an expense or loss (Probable) (more than criteria are met) account and crediting a liability 50% chance) Possible Contingent Liability Disclose Remote None Ignore (Neither recognize nor disclose) Measurement of a Provision 01 Handout 1 *Property of STI  [email protected] Page 3 of 8  BM2403 According to PAS 37, the amount recognized as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. The best estimate is the conclusion made by any technical or legal expert, which is usually based on past experiences and similar courses of events or circumstances. As stated in PAS 37, the risks and uncertainties that inevitably surround many events and circumstances shall be considered in reaching the best provision estimate. The following are the rules for arriving at the best estimate of a provision: If a single obligation is measured, the most likely outcome is the best estimate of a provision. Where there is 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 (Valix, Peralta, & Valix, 2023). The expected value is the best provision estimate if a group of items is being measured. Expected value is a statistical method of estimating provisions, which weighs all possible outcomes by their associated possibilities (Valix, Peralta, & Valix, 2023). Illustrative Problem 1 - Adapted (Putra, 2018) Perfectly Inc. is an entity that explores oil off the shores of Sea Oil Islands. It has employed oil exploration experts from around the globe. Despite all efforts, a major oil spill has grabbed the media's attention. Because of several protests, the entity has engaged lawyers to address any legal repercussions. In the past, other oil entities have had to settle with the environmentalists by paying huge amounts in out-of- court settlements. The legal counsel of Perfectly Inc. has advised that no law would require it to pay anything for the oil spill. The Government of Sea Oil Islands is currently considering such legislation, but that legislation would probably take another year to be finalized as of the date of the oil spill. However, in its television advertisements and promotional brochures, Perfectly Inc. often has clearly stated that it is very conscious of its responsibilities toward the environment and will make good any losses that may result from its exploration. This policy has been widely publicized, and the chief executive officer acknowledged this policy in official meetings when members of the public raised questions to him on this issue. Requirement: Is there any obligating event that requires Perfectly Inc. to make provision? Answer: Yes. Based on the information, the oil spill is a past obligating event resulting in a present obligation. There is no legal obligation because no legislation is in place yet that would make cleanup mandatory for any entity operating in Sea Oil Islands. However, the circumstances surrounding the issue indicate a constructive obligation since the company, with its advertised policy and public statements, has created an expectation in the public's minds that it will honor its environmental obligations. Hence, a provision should be recognized. Illustrative Problem 2 - Adapted (Putra, 2018) ABC Enterprises owns a workshop for servicing cars under warranty. In preparing its financial statements, ABC needs to ascertain the provision of warranty that it would be required to provide at year-end. The entity’s experience with warranty claims is the following: 60% of cars sold in a year have zero defects; 25% of cars sold in a year have normal defects, and 01 Handout 1 *Property of STI  [email protected] Page 4 of 8  BM2403 15% of cars sold in a year have significant defects. The cost of rectifying a “normal defect” in a car is P10,000, while the cost of rectifying a “significant defect” is P30,000. The entity sold 500 cars during the year. Requirement: Compute the amount of provision for warranty at year-end. Answer: P3,500,000 Solution: The expected value of the provision for warranty needed at year-end is: [60% x 0] + [25% x P10,000] + [15% × P30,000] = P7,000 P7,000 x 500 = P3,500,000 Illustrative Problem 3 - Adapted (Robles & Empleo, 2016) JKL Company is charged with multiple lawsuits from the stampede incident that caused the death of 80 persons. The incident was due to the sales promotion they featured on the ABC channel on Feb. 10, 2X16. JKL’s legal counsels believe that it is probable that JKL would be found liable for the incident; as of the date of the issuance of 2X16 financial statements, a reasonable estimate of the obligation is between P16,000,000 and P24,000,000. Each point within the range is as likely as any other. Requirement: Compute the amount of provision at year-end. Answer: P20,000,000 Solution and Explanation: [P16,000,000+P24,000,000] / 2 = P20,000,000 The measured provision involves many items and a continuous range of possible outcomes. There is no better estimate in the range; each point within that range is as likely as any other point. Thus, the provision shall be measured at the midpoint of the range. ACCOUNTING FOR CONTINGENT LIABILITY PAS 37, paragraph 10 defines a contingent liability in two (2) ways (Valix, Peralta, & Valix, 2023): A contingent liability is a possible obligation that arises from past events, whose existence will be confirmed only by the occurrence or non-occurrence of one (1) or more uncertain future events not wholly within the entity's control. A contingent liability is a present obligation that arises from a past event. It is not recognized for financial statement purposes because (1) it is not probable that an outflow of resources will be required to settle the obligation or (2) the obligation amount cannot be measured reliably. Accounting Treatment for Contingent Liability A contingent liability shall not be recognized in the financial statements but shall be disclosed only. The required disclosures concerning this type of liability are as follows (Valix, Peralta, & Valix, 2023): 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; and d. Possibility of any reimbursement. If contingent liability is remote, no disclosure is necessary. 01 Handout 1 *Property of STI  [email protected] Page 5 of 8  BM2403 REQUIRED DISCLOSURES For each class of provision, an entity shall disclose: The carrying amount at the beginning and end of the period; Additional provisions made in the period, including increases to existing provisions; Amounts used (i.e., incurred and charged against the provision) during the period; Unused amounts reversed during the period, and The increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate. Comparative information is not required. An entity shall disclose the following for each class of provision: A brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits; An indication of the uncertainties about the amount or timing of those outflows. Where necessary to provide adequate information, an entity shall disclose the major assumptions made concerning future events and The amount of any expected reimbursement, stating the amount of any asset recognized for that expected reimbursement. PROPOSED AMENDMENTS TO THE CLASSIFICATION & MEASUREMENT OF FINANCIAL INSTRUMENTS – EXPOSURE DRAFT MARCH 2023 (Villa, 2023) The International Accounting Standards Board (IASB) published the Exposure Draft Amendments to the Classification and Measurement of Financial Instruments in March 2023. Proposals Derecognition of financial liabilities settled through electronic transfer Assessment of contractual cash flow characteristics in classifying financial assets Disclosure of information about equity instruments at fair value through other comprehensive income and contractual terms that could change the timing or amount of contractual cash flows Derecognition of Financial Liabilities settled through Electronic Transfer The IASB has considered a criterion for allowing an entity to derecognize a financial liability before delivering cash on the settlement date. The IASB tentatively determined that a business has an accounting policy choice to derecognize a financial liability before the settlement date when: a. The entity cannot withdraw, stop or cancel an electronic payment instruction; b. The entity has lost the practical ability to access the cash as a result of the electronic payment instructions and c. The settlement risk associated with the electronic payment instruction is insignificant. Settlement risk is considered insignificant if the payment system used has these characteristics: a. The time elapsed between the payment initiation date and the settlement date is relatively short and is standardized for the particular payment system and 01 Handout 1 *Property of STI  [email protected] Page 6 of 8  BM2403 b. The execution of the payment instruction follows a typical administrative procedure, providing the debtor with reasonable certainty that the transfer will be completed and the cash handed to the creditor. The IASB tentatively decided to limit the scope of this accounting policy choice to electronic payment systems. Assessment of Contractual Cash Flow Characteristics in Classifying Financial Assets The IASB proposes to elaborate the requirements on: Elements of interest in a basic lending arrangement Contractual terms that change the timing or amount of contractual cash flows Elements of Interest in a Basic Lending Arrangement To help an entity assess whether the interest it receives in an arrangement is consistent with a basic lending arrangement, the IASB proposes to clarify that: 1. The assessment of interest focuses on what an entity is being compensated for rather than how much compensation an entity receives and 2. Contractual cash flows are inconsistent with a basic lending arrangement if: The cash flows include compensation for risks or market factors not typically considered basic lending risks or costs, even if such terms are common in the market and The cash flows change in a way that is not aligned with the direction and magnitude of changes in lending risks or costs. Contractual terms that change the timing or amount of contractual cash flows To help entities assess whether such financial assets meet the SPPI requirement, the IASB proposes to clarify that: An entity shall assess whether the contractually specified change would meet the SPPI requirement irrespective of the probability of the contingent event occurring; A change in contractual cash flows is consistent with a basic lending arrangement if the occurrence (or non-occurrence) of the contingent event is specific to the debtor and The resulting contractual cash flows should represent neither an investment in the debtor nor an exposure to the performance of specified assets. Disclosure of Information about Equity Instruments at Fair Value through Other Comprehensive Income Proposed Disclosures The change in fair value of investments in equity instruments during the reporting period, showing separately the amount of that change related to investments derecognized during the reporting period and the amount related to investments held at the end of the reporting period. The aggregate fair value of investments in equity instruments at the end of the reporting period. Disclosure of Information about Contractual Terms that Could Change the Timing or Amount of Contractual Cash Flows A qualitative description of the nature of the contingent event. 01 Handout 1 *Property of STI  [email protected] Page 7 of 8  BM2403 Quantitative information about the range of changes to contractual cash flows that could result from the contractual terms. The gross carrying amount of financial assets and the amortized cost of financial liabilities are subject to those contractual terms. References International Financial Reporting Standards. (2001). IAS 1 Presentation of Financial Statements. Retrieved from https://www.ifrs.org: https://www.ifrs.org/issued-standards/list-of- standards/ias-1-presentation-of-financial-statements/ International Financial Reporting Standards. (2001, April). IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Retrieved from https://www.ifrs.org: https://www.ifrs.org/issued- standards/list-of-standards/ias-37-provisions-contingent-liabilities-and-contingent-assets/ International Financial Reporting Standards. (2017). IFRS 9 Financial Instruments. Retrieved from https://www.ifrs.org: https://www.ifrs.org/issued-standards/list-of-standards/ifrs-9-financial- instruments/ Putra, L. D. (2018). Recognition and Measurement of Provision. Retrieved from http://accounting- financial-tax.com: http://accounting-financial-tax.com/2009/04/recognition-and-measurement- of-provision-adapted-from-ias-37/ Robles, N. S., & Empleo, P. M. (2016). Intermediate Accounting Volume 1. Mandaluyong: Millenium Books, Inc. Valix, C. T., Peralta, J. F., & Valix, C. A. (2023). Intermediate Accounting Vol. 2. Manila: GIC Enterprises & Co., Inc. Villa, J. J. (2023). IFRS UPCOMING ISSUANCES. 01 Handout 1 *Property of STI  [email protected] Page 8 of 8