INTERMEDIATE ACCOUNTING 2 1st Semester, AY 2022-2023

Learning Material 1
LIABILITIES

A. Discussion of Accounting Principles

1. Liabilities are present obligations of an entity to transfer an economic resource as a result of

past events (i.e., the Revised Conceptual Framework for Financial Reporting).

 The essential characteristics of an accounting liability include:

a. The entity has a present obligation - there is a responsibility on the part of the entity to
pay the payee to whom the obligation is owed.

b. The obligation is to transfer an economic resource - the economic resource is the

asset that represents a right with a potential to produce economic benefits. 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 - the liability is not recognized until it is incurred.

2. The 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.

 Legal obligation is a consequence of a binding contract or statutoty requirement (e.g.,

accounts payable for goods and services received).

 Constructive obligation gives rise to liabilities by reason of normal business practice.

3. There is no accounting liability without payment of money, without transfer of noncash asset,
and/or without performance of service.

 An accounting liability arises when an entity declares cash dividend: hence, the
obligation to pay cash.

 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.

4. A liability must arise from a past transaction or event. The past transaction is an obligating
event which creates a present obligation.
For example, the acquisition of goods gives rise to accounts payable; or the receipt of a
bank loan results in an obligation to pay the loan.

5. Common Types of Liabilities

 Accounts payable to suppliers for the purchase of goods

 Amounts withheld from employees for taxes, product warranties, and profit sharing
bonus
 Accruals for salaries, interest, rent, taxes, product warranties, and profit sharing
bonus
 Cash dividends declared but not paid
 Deposits and advances from customers
 Debt obligations for borrowed funds – notes, mortgages and bonds payable
 Income tax payable
6. Measurement of Current Liabilities

 All liabilities are initially measured at present value and subsequently measured at
amortized cost.
  The discount or the difference between the face amount and the present value is
usually not material so it is ignored.

Current liabilities or short-term obligations are no longer discounted instead such are
measured, recorded and reported at face amount.

7. Measurement of Noncurrent Liabilities

 Initially measured at present value and subsequently measured at amortized cost as in

the case of bonds payable and noninterest-bearing note payable.

 Initially and subsequently measured at face amount as in the case of a long-term note
payable.

8. Current Liabilities (see PAS 1, paragraph 69)

 The entity expects to settle the liability within the entity’s operating cycle.

 The entity holds the liability primarily for the purpose of trading.

 The liability is due to be settled within 12 months after the reporting period.

 The entity does not have an unconditional right to defer settlement of the liability for at
least 12 months after the reporting period.

Trade payables and accruals for employees 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.

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 the
purpose of trading. Examples of these current liabilities are 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 liabilities 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.

9. Noncurrent Liabilities refers to all liabilities not classified as current. These noncurrent
liabilities include:
 Noncurrent portion of long-term debt
 Finance lease liability
 Deferred tax liability
 Long-term obligation to officers
 Long term deferred revenue

10. Long-term Debt Falling Due Within One Year

 A liability which is due to be settled within 12 months after the reporting period is
classified as current, even if the original term was for a period longer than 12 months.

 An agreement to refinance or to reschedule payment on a long-term basis is completed

after the reporting and before the financial statements are authorized for issue.

 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—the obligation is classified as noncurrent.

 If the entity has the entity has the right at the end of the reporting period to roll over an
obligation for at least 12 months after the reporting period under an existing loan facility,
the obligation is classified as noncurrent even if it would be due within a shorter period.

 The right to defer settlement for at least 12 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.

11. Covenants

a. These are often attached to borrowing agreements which represent undertakings by the
borrower.

b. These are actually restrictions on the borrower as to undertaking further borrowings,

paying dividends, maintaining specified level of working capital, etc.

12. Breach of Covenants

a. Under the covenants or agreements, if certain conditions are breached or violated, the
liability becomes payable on demand.

b. As provided in PAS 1, paragraph 74, the liability that has become payable on demand is
classified as current even if the lender has agreed, after the reporting period and before
the financial statements are authorized for issue, not to demand payment as
consequence of the breach or violation.
This liability is classified as current because at the end of the reporting period, the entity
does not have the right to defer settlement for at least 12 months after the end of
reporting period.

c. The liability is classified as noncurrent if the lender has agreed on or before the end of
the reporting period to provide a grace period ending at least 12 months after the end of
reporting period.
Take note, a grace period is a period within which the entity can rectify the breach and
during which the lender cannot demand immediate repayment.

13. Presentation of Current Liabilities

a. As a minimum, the face of the statement of financial position shall include the following
line items for current liabilities.
 Trade and other payables
 Current provisions
 Short-term borrowing
 Current portion of long-term debt
 Current tax liability

b. 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.

14. Estimated Liabilities

a. These are obligations which exist at the end of reporting period although their amount is
not definite.

b. 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.

Given these circumstances, still the existence of the estimated liabilities is valid and
unquestioned.

c. Estimated liabilities are either current or noncurrent.

Examples of estimated liabilities include estimated liability for premium, award points,
warranties, gift certificates, and bonus.

15. Deferred Revenue or Unearned Revenue

a. It is an income already received but not yet earned.

 b. It is realizable within one year or in more than one year after the end of the reporting
period.

c. If it is realizable within one year, it is a current liability. Typical examples are unearned
interest income, unearned rental income and unearned subscription revenue.

d. If it is realizable in more than one year, it is a noncurrent liability.

Examples of noncurrent deferred revenue are unearned revenue from long-term service
contracts and long-term leasehold advances.

16. Bonus

a. Large companies often compensate key officers and employees by way of bonus for
superior income realized during the year.

b. The main purpose of this scheme is to motivate officers and employees by directly
relating their well-being to the success of the entity.

c. This compensation plans results in liability that must be measured and reported in the
financial statements.

17. 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 bonus.

A problem is given in the Application Exercises and it was computed using the four
variations.

B. Application Exercises

You are provided with exercises and the corresponding solutions. The objective is to
demonstrate the application of accounting principles discussed for liabilities.

Exercise 1

On December 31, 2021, Ryan Company provided the following information:

Accounts payable, including deposits and advances from customers of

P125,000. 625,000
Notes payable, including note payable to bank due on December 31, 2023 of
P250,000 750,000
Share dividend payable 200,000
Credit balances in customers’ accounts 100,000
Serial bonds payable in semiannual installments of P250,000 2,500,000
Accrued interest on bonds payable 75,000
Contested BIR tax assessment – possible obligation 150,000
Deferred rent income 50,000

Required:
Compute the total current liabilities on December 31, 2021.

Solution to Exercise 1
Accounts payable 500,000
Deposits and advances from customers 125,000
Notes payable 500,000
Credit balances in customers’ accounts 100,000
Serial bonds payable 500,000
Accrued interest on bonds payable 75,000
Deferred rent income 50,000
Total current liabilities 1,850,000
Notes:
a. Accounts payable includes solely an obligation arising from purchases on account of merchandise for trading
purposes by the entity.
b. Deposits and advances from customers is a current liability since none has been given yet in exchange to such
deposits and advances. As per the law on obligations and contracts, “no one is entitled to anything at the
expense of others”.
c. Only the note payable is a current liability. The note payable to bank is a noncurrent liability considering its due
date on December 31, 2023.
d. Serial bonds payable due for one year (P250,000 x 2) is the current liability.
e. The contested BIR tax assessment is a possible obligation. It only needs a disclosure in the statement of financial
position. There is an outflow of resources if the event is regarded as “probable” meaning it is more than 50%
likely or substantially more. A possible obligation is 50% or less likely to occur (see Provision for Contingent
Liability).
f. Deferred rent income or unearned rent income is a current liability.
g. Share dividend payable is not a current liability. The obligation here is to issue the entity’s own shares –
accounted for under shareholders’ equity.

Exercise 2

Paul Company provided the following information on December 31, 2021:

Notes payable: Trade 1,500,000

Bank loans 1,000,000
Advances from officers 250,000
Accounts payable – trade 2,000,000
Bank overdraft 150,000
Dividends payable 500,000
Withholding tax payable 50,000
Mortgage payable 1,900,000
Income tax payable 400,000
Estimated warranty liability 300,000
Estimated damages payable by reason of breach of contract 350,000
Accrued liabilities 450,000
Estimated premium liability 100,000
Claim for increase in wages by employees covered in a pending lawsuit 1,750,000
Contract entered into for the construction of building 2,500,000

Required:
Determine the total current liabilities on December 31, 2021.

Solution to Exercise 2

Notes payable – trade 1,500,000

Notes payable – bank 1,000,000
Notes payable – officers 250,000
Accounts payable – trade 2,000,000
Bank overdraft 150,000
Dividends payable 500,000
Withholding tax payable 50,000
Income tax payable 400,000
Estimated warranty liability 300,000
Estimated damages payable 350,000
Accrued liabilities 450,000
Estimated premium liability 100,000
Total current liabilities 7,050,000

Notes:
a. Mortgage payable is a noncurrent liability.
b. Claim for increase in wages by employees is currently under litigation. It is not yet a liability pending
appropriate decision.
c. The contract entered into for the construction of building is not yet a liability since there is no transfer of
economic resource as none has been started yet in the construction of the building.

Exercise 3

Apol Company provided the following information on December 31, 2021:

Accounts payable after deducting debit balances in supplier’s accounts of
P200,000. 1,000,000
Accrued liabilities 100,000
Note payable – due March 31, 2022 2,000,000
 Note payable – due May 1, 2022 1,600,000
Bonds payable – due December 31, 2023 4,000,000

On March 1, 2022 before the 2021 financial statements were issued, the note payable of
P2,000,000 was replaced by an 18-month note for the same amount. The entity is considering
similar action on the P1,600,000 note due on May 1, 2022. The financial statements were
issued on March 31, 2022.

Required:
1. Ascertain the total current liabilities
2. Ascertain the total noncurrent liabilities

Solution to Exercise 3

1. Accounts payable 1,000,000

Accrued liabilities 100,000
Note payable – due May 1, 2022 1,600,000
Total current liabilities 2,700,000

2. Note payable – refinanced 2,000,000

Bonds payable – due December 31, 2023 4,000,000
Total noncurrent liabilities 6,000,000

Notes:
a. The note payable of P1,600,000 is still classified as current liability because the intent to refinance was not
consummated before the issuance of financial statements.
b. The note payable of P2,000,000 was replaced by an 18-month note before the issuance of financial statements;
hence, it is already classified as a noncurrent liability.

Exercise 4

Brilliant Company has an agreement to pay the sales manager a bonus of 5% of the entity’s
earnings. The income for the year before bonus and tax is P5,250,000. The income tax rate is
30% of income after bonus.

Required:
Determine the bonus under each of the following independent assumptions:
1. Bonus is a certain percent of the income before bonus and before tax.
2. Bonus is a certain percent of income after bonus but before tax.
3. Bonus is a certain percent of income after bonus and after tax.
4. Bonus is a certain percent of income after tax but before bonus.

Solution to Exercise 4

Given data:
Income before bonus and before tax 5,250,000
Bonus 5%
Tax 30%

1. Bonus is a certain percent of the income before bonus and before tax.
Income before bonus and before tax 5,250,000
Multiply by bonus rate .05
Bonus 262,500

2. Bonus is a certain percent of income after bonus but before tax.

B = .05 (5,250,000 – B)
B = 262,500 - .05B
B + .05B = 262,500
B = 262,500/1.05
B = 250,000

Proof:
Income before bonus and before tax 5,250,000
Less: Bonus 250,000
Income after bonus but before tax 5,000,000
Multiply by bonus rate .05
Bonus 250,000
3. Bonus is a certain percent of income after bonus and after tax.
B = .05 (5,250,000 – B - T)
T = .30 (5,250,000 – B)
B = .05 [5,250,000 – B - .30 (5,250,000 – B)]
B = .05 (5,250,000 – B – 1,575,000 + .30B)
B = 262,500 - .05B – 78,750 + .015B
B + .05B - .015B = 262,500 – 78,750
1.035B = 183,750
B = 183,750/1.035
B = 177,536
T = .30 (5,250,000 – 177,536)
T = 1,521,739

Proof:
Income before bonus and before tax 5,250,000
Bonus ( 177,536)
Tax (1,521,739)
Income after bonus and after tax 3,550,725
Multiply by Bonus rate .05
Bonus 177,536

4. Bonus is a certain percent of income after tax but before bonus.

B = .05 (5,250,000 – T)
T = .30 (5,250,000 – B)
B = .05 [5,250,000 - .30 (5,250,000 – B)]
B = .05 (5,250,000 – 1,575,000 + .30B)
B = 262,500 – 78,750 + .015B
B - .015B = 262,500 – 78,750
.985B = 183,750
B = 183,750/.985
B = 186,548
Proof:
Income before bonus and before tax 5,250,000
Tax (5,250,000 – 186,548 x 30%) (1,519,036)
Income after tax but before bonus 3,730,964
Multiply by Bonus rate .05
Bonus 186,548

*****