Liabilities

Question 1

A liability is defined as:
Aka what is the definition test

Answer 1

‘A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.’

Question 2

Current and Non-current Liabilities

What is a liability?
When does it arise?
What must the amount owed must be able to do?
How are liabilities split?

Answer 2

• A liability is an amount owing at the end of the reporting period which a business is under an obligation to pay
• It arises because a benefit has been received by the business but not fully paid for
• The amount owing must be able to be determined with substantial accuracy
• Liabilities are split between current (<12m and non-current (>12m)

Question 3

Recognition test
A liability is recognised in the SOFP when:(2)
What if it doesn’t

Answer 3

• It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation; and
• The amount at which the settlement will take place can be measured reliably

Non-recognition: Liabilities that pass definition test but fail recognition test

Question 4

The issue of uncertainty

What do we do when a known liability exists but the amount of the obligation is not certain?

What is a contingent liability?

What is the issue of uncertainty?

Answer 4

• When a known liability exists but the amount of the obligation is not certain, a provision can be made for the best estimate
• A contingent liability exists where the obligation to pay is dependent on a future event
• Clear subjectivity which can lead to manipulation

Question 5

What is big bath accounting

What accounting standard aims to prevent and what does it do?

Answer 5

Big bath accounting refers to the practice where companies manipulate their financial statements to make poor results look even worse, thereby setting themselves up for a better performance in future periods. This is often done by taking large provisions (expenses) in one period, which can later be reversed, improving future profitability.

IAS 37 is the international standard that aims to prevent this practice by providing guidelines on how to account for provisions, contingent liabilities, and contingent assets.

Question 6

Big bath provisions

What is an example?
What do you do in terms of bigger and smaller provisions

Answer 6

• ‘Old’ versus ‘new’ management scenario (showing that you have made improvements)
• New/bigger provision = charge against profit
• Smaller provision needed = credit to profit

Question 7

IAS __ Provisions, contingent liabilities and contingent assets

What are the key objectives (2)
Key aim?
Key principles (2)

Answer 7

IAS 37 Provisions, contingent liabilities and contingent assets

Key objectives:

• Appropriate recognition and measurement criteria
• Sufficient disclosure to aid users to understand nature, timing and amount

Key aim

• To ensure only genuine obligations dealt with in Financial Statements

Key principle

• A provision should be recognised when there is a liability
• A liability is a present obligation resulting from past events

Question 8

Recognition of a provision – three criteria approach

Answer 8

“A provision shall be recognised when:

1. an entity has a present obligation (legal or constructive) as a result of a past event; (Obligating event – no alternative to settling the obligation)
2. it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation;(More likely than not (> 50%))
   and
3. a reliable estimate can be made of the amount of the obligation.” (Best estimate – amount that would be rationally paid to a 3rd party)

Question 9

Depreciation and bad debts (2)

Answer 9

• Depreciation or bad debts are not considered to be provisions
• They reduce the carrying value of the related asset

It is the reduction of an asset, not the creation of a liability;

Can be called an allowance for receivables

Question 10

Double entry for most provisions (picture)

Answer 10

Question 11

Liability decision tree - IAS 37 (picture)

Answer 11

Question 12

Measurement of provisions

2 types and how are they measured (2,1)

Answer 12

Recognition to be the best (most realistic) estimate required to settle obligation

Provisions for ‘one-offs’

• Measured at their ‘most likely’ amounts
• Discounted present values should be used if the time value of money is material

Provisions for large populations

• Measured at a probability-weighted expected value

Question 13

IAS 37 Disclosure (picture) (2)

Answer 13

• Can’t be general provisions, have to be classed
• Narrative: Brief description of nature, timing of outflows, uncertainties and amount of expected reimbursement

Question 14

Range of outcomes = large populations

Answer 14

Question 15

Onerous contracts (definition and example)

Answer 15

An onerous contract is one entered into with another party under which the unavoidable costs of fulfilling the contract exceed the revenues to be received and where the entity would have to pay compensation if the contract was not fulfilled.

E.g. leased premises where it has been impossible to sublet

Question 16

Restructuring Provisions (3)

Answer 16

• A constructive obligation arises only when an entity has a detailed formal plan for the restructuring
• Has raised a valid expectation that it will carry it out by starting to implement it or announcing its main features to those affected by it
• Should only include costs directly arising from the restructuring

expenses

Question 17

Environmental liabilities or decommissioning costs (2 and effect)

Answer 17

• Environmental liability: If entity is obliged, legally or constructively to carry out restorative work or rectify environmental damage then a provision is recognised
• Decommissioning cost: often relate to non-current assets e.g. power stations.
  Added to cost of non-current asset as follows:

Question 18

Contingent liabilities

A contingent liability should be ____________ when one or more of the requirements for a provision are not met: (3)

Treatment (3)

Answer 18

A contingent liability should be disclosed when one or more of the requirements for a provision are not met:

• A possible obligation exists, and/or
• An outflow of economic benefits is not probable, and/or
• The amount cannot be measured with sufficient reliability

  - Not to be recognised in Statement of Financial Position
  - Only to be disclosed unless possibility of transfer is remote
  - Disclosure to include nature of contingency uncertainties expected to affect final outcome estimate of (potential) financial effect

Question 19

Contingent assets (5)

Only recognise as an asset if?
Disclosed if?

Answer 19

A contingent asset is a possible asset that arises from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the entity

• Recognise only if virtually certain (no longer contingent)
• If economic benefits are probable – disclose in a note
• If less than probable – no disclosure
• Not to be recognised in Statement of Financial Position
• Only to be disclosed where inflow of economic benefits is probable

Disclosure to include:

• nature of contingency
• uncertainties expected to affect final outcome
• estimate of (potential) financial effect