Colegio de San Juan de Letran Calamba

Calamba City, Laguna, Philippines

Act033D – financial accounting

MODULE 5 - LIABILITIES

Lesson 5.1 – Accounting for liabilities

Lesson 5.2 – Recognition and measurement of liabilities
Lesson 5.3 – Initial and subsequent measurement of liabilities
ACT033D – FINANCIAL ACCOUNTING
Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

Lesson 5.4 – Classification of

liabilities

Lesson 5.1 – Accounting for liabilities

The Conceptual Framework for Financial Reporting defines liabilities as “present obligation 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”. (Valix C.T. Peralta & Valix C.M.
2013)

Present obligation may be a legal obligation or a constructive obligation.

• Legal obligation is a duty or responsibility to act or perform in a certain way which may be
legally enforceable as a consequence of a binding contract or statutory requirement. Examples are
accounts payable (arising from a contract with a supplier), withholding taxes payable and value added
taxes payable (arising from legislation and other operation of law)
• Constructive obligation also gives rise to liability by reason of normal business practice,
custom and a desire to maintain good business relations or at in an equitable manner. For example, an
entity, as a matter of policy an entity decides to rectify faults in its products even when these become
apparent after the warranty period had expired.
The liability arises from a past event. Liability is not recognized until it is incurred. The past event
that leads to a legal or constructive obligation is known as the obligating event. The obligating event
creates a present obligation because the entity has no realistic alternative but to settle the obligation
created by the event. The acquisition of goods gives rise to accounts payable. The obligating event is the
acquisition of goods.
The settlement of a liability requires an outflow of resources embodying economic benefits –
this requirement is the definition of accounting liability. The obligation is to pay cash, transfer a noncash
asset or provide service at some future time. Without payment of cash, or without transfer of a noncash
asset, or without the performance of service, there is no accounting liability. When an entity declares
dividend, there is created an obligation to pay cash, hence accounting liability exists. But when an entity
declares a stock dividend, there is no accounting liability created. The obligation is the issuance of the
entity’s own shares, and such issuance is not a transfer of cash, noncash asset or performance of a
service. Thus stock dividend payable is classified as part of equity rather than an accounting liability.

Common Types of Liabilities

The following are the most commonly used types of liabilities:
• Accounts payable to suppliers for the purchase of goods or services;
• Amounts withheld from employees or other parties for taxes and for contributions to the
Social Security System (SSS) or to a pension fund;
• Accruals for wages, interest, royalties, taxes, product warranties, and profit-
sharing plans;
ACT033D – FINANCIAL ACCOUNTING
Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

• Dividends (not stock

dividends) declared but not paid;
• Deposits and advances from customers and officers;
• Debt obligations for borrowed funds – notes, mortgages and bonds payable;
• Income tax payable;
• Unearned revenue.

Lesson 5.2 – Recognition and measurement of liabilities

A liability is recorded and reported on the balance sheet when the following conditions are met:
• It is probable that an outflow of resources representing economic benefits will result from
the settlement of a present obligation; an outflow of resources is considered probable when
the event is more likely to occur than not to occur.
• The amount at which the settlement will take place can be measured reliably; measurement
is a sub-process of recognition; it is the assigning of peso amount to a financial statement
element; it is not necessary that the amount of the probable obligation be measured with
precision; the use of estimates may sometimes be essential and does not undermine the
reliability of the financial statements.

Lesson 5.3 – Initial and subsequent measurement of liabilities

PFRS 9 para. 5.1.1 provides that an entity shall measure initially a financial liability at its fair
value through profit or loss, or fair value at amortized cost. When measured initially at its fair value
through profit or loss, transaction costs that are directly attributable to the issue of the financial liability
are expensed immediately .
In other words, transaction costs are included in the initial measurement of a financial liability
measured at amortized cost, but are expensed immediately if the financial liability is designated initially
as at fair value through profit or loss.
Transaction costs are incremental costs that are directly attributable to the issue of financial
liability. An incremental cost is one that would not have been incurred if the entity had not issued the
financial liability. Transaction costs include fees and commissions paid to agents, advisers, brokers, and
dealers; levies by regulatory agencies and securities exchanges, and transfer taxes and duties.
Transaction costs do not include debt premiums or discounts, financing costs, internal administrative or
holding costs.

Fair value is the amount for which a liability is settled between knowledgeable and willing parties in an
arm’s length transaction. In other words, the “fair value” of a liability is equal to the present value of the
future cash payments to settle the obligation. The term “present value” is the discounted amount of the
future cash outflows in settling an obligation using the market rate of interest.

Subsequent Measurement of Liabilities

After initial recognition, an entity shall measure a financial liability:
(1) At amortized cost using the effective interest method, and

ACT033D – FINANCIAL ACCOUNTING

Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

(2) At fair value through profit or

loss.

The “amortized cost” of a financial liability is the amount at which the financial liability is
measured at initial recognition minus principal repayment, plus or minus the cumulative amortization
using the effective interest method of any difference between the initial amount and the maturity
amount. Simply stated, the difference between the face amount and present value of the financial
liability is amortized to interest expense using the effective interest method. The difference between the
face amount and the present value is either discount or premium on the issue of financial liability.

Lesson 5.4 – Classification of liabilities

Under PAS 1 on presentation of financial statements, liabilities are classified into two, namely:
• Current Liabilities
Liabilities are classified as current if:
◊ 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.

♦ Accounts Payable also known as trade accounts payable are liabilities arising from the
purchase of goods, materials, supplies or services on an open charge-account basis. The credit
time period generally varies from 30 to 120 days without any interest being charged on the
deferred payment. Most accounting systems are designed to record liabilities for purchases of
goods when the goods are received, or practically when the invoices are received from the
supplier. (N. Robles & P. Empleo, Intermediate Accounting Volume 2)

♦ Notes Payable – a promissory note is a written promise to pay a certain sum of money to the
bearer at a designated future time. The notes may arise either from a trade situation like the

purchase of goods or services on credit or the borrowing of money from a bank. Notes payable
can either be interest-bearing or non-interest bearing.
○ Accounting for the issuance of interest-bearing note is relatively straightforward.
Since the note is interest bearing and assuming that the stated rate approximates the
prevailing market rate for similar obligations, the present value of the note at the time
of its issuance is its face value.
○ Accounting for a non-interest bearing note is slightly more complex. A non-interest
bearing note does not explicitly state an interest rate on the face of the note. It does not
mean, however, that there is no interest imputed on the original obligation. A non-
interest bearing note is simply written in the form where the interest is imputed on the
face value of the note. Thus the face value represents the present value of the
ACT033D – FINANCIAL ACCOUNTING
Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

obligation
plus the imputed interest for the term of the note.

♦ Accrued Liabilities – consists of obligations for expenses on or before the balance sheet date
but payable at a later date. Accrued liabilities include those payable to specific persons and
determinable with reasonable accuracy. They also include provisions. Common examples of
liabilities of this nature are accrued salaries, accrued interests, accrued rentals, and accrued
taxes. An accrued liability is taken up as an adjustment at year end by charging an expense
account and crediting an accrued liability account.

♦ Liability for Bonuses – as incentives to officers and managers, many companies establish a
bonus agreement, with the bonus usually payable shortly after the end of the year. The amount
of bonus may be based on the amount of revenue or profit of the enterprise. The bonus is an
effect, part of salaries or compensation expense and is reported as an operating expense of the
company. The bonus, if unpaid at year end, should be accrued by debiting Compensation
Expense (or Bonus Expense) and crediting Bonus Payable. The amount of bonus, if based on
profit, is computed using different possible formulas:
○ The bonus is expressed as a certain percent of income before bonus and before tax
○ The bonus is expressed as a certain percent of income after bonus but before tax
○ The bonus is expressed as a certain percent of income after bonus and after tax
○ The bonus is expressed as a certain percent of income after tax but before bonus

♦ Dividends Payable – a cash dividend payable is an amount owed by a corporation to its

shareholders as a result of the action of the board of directors on the distribution of corporate
earnings in the form of cash. It is recorded and recognized in the accounts upon declaration by

Board of Directors. Cash dividends are usually payable within one (1) year of declaration and
therefore, classified as current liabilities.

Undeclared cash dividends on cumulative preference shares (dividends in arrears) are not
recognized as liabilities because there is no obligating event. Dividend in arrears on cumulative
preference shares are simply disclosed in the notes to financial statements.

A property dividend and a scrip dividend will result in the creation of current liability because
they are generally distributable within a relatively short period of time after declaration and
would require the outflow of resources for their settlement.

A share dividend distributable is not classified as a liability on the balance sheet

because it would not require outflow from the enterprise of resources embodying
economic benefits. The distribution of such a dividend merely involves the
ACT033D – FINANCIAL ACCOUNTING
Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

issuance of additional shares

of the entity’s capital without consideration. Share dividend distributable is presented as part of
contributed capital in the equity section of the balance sheet.

♦ Deposits and Advances – consist of cash or property received but which are returnable to the
depositor or which have been collected or otherwise accumulated to be remitted to third
parties (such as fund held for others).

If the deposit or advance results from the company’s operating activities (e.g., deposits on
returnable containers received by a company whose products, such as San Miguel Beer, Coca-
Cola, Pepsi Cola are sold on returnable containers), the liability is normally reported as current.

If the deposit is non-trade and is expected to be refunded or paid after more than one year (as
in the case of deposit to utility companies and security deposits on long-term leases), the
liability is reported as non-current.

♦ Unearned Revenues are amounts collected in advance that have not yet been earned and
recorded as revenues pending collection of the earning process. Examples are advances for
interest, rent, magazine subscriptions, royalties, tickets, tokens, gift certificates, and service
contracts.

♦ Current Portion of Long-term Debt – the portion of long-term debt that is due within 12
months

From the balance sheet date is classified as part of current liabilities. Examples are currently
maturing portion of bonds, mortgage notes, and other long-term indebtedness. However, the
currently maturing portion of the debt, in which the company has the discretion to refinance or
roll over within a period of more than twelve months from the balance sheet date shall continue
to be classified as non-current.

♦ Taxes and Employee-Related Liabilities

○ Value-added Taxes are taxes levied on the transfer of tangible personal property and
certain services. It must be collected from the customer by the seller and
remitted on a monthly basis, to the proper government authority (i.e., Bureau of
Internal Revenue). The VAT is reported as a current liability until they are remitted to
the BIR in the following period.
○ Payroll Taxes – employers are required by law to withhold from the salaries of each
employee an amount representing income taxes payable by employees, as well as
employee’s share of SSS premiums, Phil-Health contribution, Pag-ibig contribution,
group insurance, union dues, and various other amounts payable by employees to third
ACT033D – FINANCIAL ACCOUNTING
Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

parties.
These amounts withheld from the employees’ salaries are reported as current liabilities
of the withholding company until they are remitted to the appropriate parties.

♦ Cash Discounts – the agreement for the purchase of goods usually includes incentives for
early payment of the account; thus, cash discounts are offered. The purchase transaction may
be recorded using either the gross method or the net method.
○ Gross method: the Purchase account and the Accounts Payable account are recorded
at the gross invoice price. A cash discount taken on purchases is recorded upon payment
as Purchase Discounts. Any balance of Purchase Discounts is reported on the income
statement as a deduction from gross purchases.
○ Net method: both the Purchases and Accounts Payable are initially recorded at
invoice price less the cash discounts available. A cash discount not taken is recorded as
Purchase Discount Lost, which is reported on the income statement as part of finance
cost.

♦ Provisions is an existing liability of uncertain timing or uncertain amount. This uncertainty

about the timing or amount distinguishes provision from other liabilities. (C. Valix, J. Peralta &
C.A. Valix, Financial Accounting Volume 2)

The liability definitely exists at the end of the reporting period but the amount is indefinite or
the

date when the obligation is due is also indefinite, and in some cases, the payee cannot be
identified or determined. The provision may be the equivalent of an estimated liability or a loss
contingency that is accrued because it is both probable and measurable. Examples are:
○ warranties – legal obligation arise from the obligating event which is the sale of the
product; the best estimate of the cost is recognized as a provision.
○ Product and Service Warranties – warranty agreements to correct product deficiency
on quality, quantity or performance creates the legal obligation arising from the
obligating event of product sale; the expected costs shall be recognized as expense for
the period and deducted from the sales of the period.
○ Premiums and coupons – The costs of these premiums and coupons shall be matched
as expenses against revenues in the period of sale. At the end of the reporting period in
which the sale is made, an estimate must be made of outstanding premium offers that
will be presented for future redemption.
○ Environmental Contamination – if an entity had an environmental policy which will
expect such entity to clean up any contamination of the environment if the entity has
broken current environmental legislation, a provision for environmental damage shall
be made.
ACT033D – FINANCIAL ACCOUNTING
Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

○
Decommissioning or Abandonment Costs – when an oil entity purchases initially an oil
field, it is put under a legal obligation to decommission the side at the end of its life. The
costs of abandonment or decommissioning shall be recognized as a provision and may
be capitalized as a cost of the oil field.
○ Court Case – when an entity is sued for damages in a court case and it is probable that
the entity may be found liable, a provision is recognized for the best estimate of the
damages.
○ Guarantee – when an entity becomes a guarantor for another entity, and such other
entity becomes bankrupt, a provision in the amount of the guarantee should be made as
it is probable that it will be required to honor its guarantee obligation.

♦ Contingent Liabilities are defined by PAS 37 as:

○ possible obligations that arise from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity;
○ present obligations that arise 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 measured reliably.

The second definition states that a contingent liability is a present obligation. However, the
present obligation is either probable or measurable but not both, hence it is considered
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.

• Non-Current Liabilities
All liabilities which fail to meet any one of the criteria for classification as current liabilities shall
be on the balance sheet as non-current. Thus, the portion of obligations not directly related to the
normal operating cycle of the enterprise are classified as non-current if they are expected to be settled
beyond 12 months after the balance sheet date and they are not held mainly for trading purposes. Non-
current liabilities also include obligations where the enterprise has an unconditional right to defer
settlement for more than 12 months after the balance sheet date.

The most common type of non-current liabilities are long-term bank borrowings, notes,
mortgages and similar obligations which are related to the general financial condition of the enterprise
rather than to the operating cycle and are due beyond 12 months from the balance sheet date.
Liabilities arising from finance leases that are not due within twelve months from the balance sheet date
and deferred income tax liabilities are also classified as non-current liabilities.

Bonds Payable
ACT033D – FINANCIAL ACCOUNTING
Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

A bond payable is a certificate

of indebtedness whereby the borrower agrees to pay a sum of money at a specific future date plus
periodic interest payments at the stated rate. They are commonly issued in denominations of say
₱1,000, ₱5,000, or ₱10,000, referred to as face value or par value. Normally a corporation sells all of its
bonds to an investment firm, referred to as an underwriter, which resells the bonds to the investing
public. In some instances, bonds are sold directly to investors.
The contract between the issuing corporation and the bondholder is known as the bond
indenture. The bond indenture specifies the terms of the bonds, rights, and duties of both parties,
restrictions on the issuing corporation and all other important details affecting the contracting parties.
The most common distinguishing characteristics and types of bonds are:
♦ Term and Serial Bonds
○ Term bonds are bonds with a single date of maturity. Term bonds may require the
issuing entity to establish a sinking fund to provide adequate money to retire the bond
issue at one time.
○ Serial bonds are bonds with a series of maturity dates instead of a single one. In
other words, serial bonds allow the issuing entity to retire the bonds by installments.

♦ Secured and Unsecured Bonds

○ Mortgage bonds are bonds secured by a mortgage on real properties, These bonds
may be first mortgage bonds or bonds with senior claims on entity assets, or second
mortgage bonds with subordinated claims on entity assets.
○ Collateral trust bonds are bonds secured by stocks and bonds of other corporations.
○ Debenture bonds are bonds without collateral security. These bonds are unsecured
and therefore rank as general creditors in the preference of credits.

♦ Registered and Bearer Bonds

○ Registered Bonds require the registration of the name of the bondholders on the
books of the corporation. If the bondholder sells a bond, the old bond certificate is
surrendered to the entity and a new bond certificate is issued to the buyer. Interest is
periodically paid by the issuing entity to the bondholders of record.
○ Coupon or Bearer Bonds are unregistered bonds in the sense that the name of the
bondholder is not recorded on the entity books. The issuing entity does not maintain a
record of who owns the bonds at any point in time. Thus, interest on coupon bonds is
paid to the person submitting a detachable interest coupon.

♦ Convertible Bonds are bonds that can be exchanged for shares of issuing entity.
♦ Callable Bonds are bonds which may be called in for redemption prior to the maturity date.
♦ Guaranteed Bonds are bonds issued whereby another party promises to make
payment if the borrower fails to do so.

ACT033D – FINANCIAL ACCOUNTING

Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

♦ Junk Bonds are high-risk,

high-yield bonds issued by entities that are heavily indebted or otherwise in weak financial
condition.

There are two (2) approaches in accounting for the authorization and issuance of bonds:
♦ Memorandum approach – In this approach, no entry upon the authorization of the entity to
issue bonds. Authorized bonds payable account is not maintained.
♦ Journal entry approach – In this approach, a journal entry is made to record the authorized
bonds payable.

Issuance of bonds may be on premium or discount.

♦ If the sales price is more than the face value of the bonds, the bonds are said to be sold at a
premium. The bond premium is however not reported as an outright gain. When the bonds are
sold at a premium, it means that the investor or buyer is amenable to receive interest that is

somewhat less than the nominal or stated rate of interest. Thus, in such a case, the effective
rate is less than the nominal of interest. The nominal rate of interest is the rate appearing on the
face of the bond certificate. It is that interest which the issuing entity periodically pays to the
buyer or bondholder. When the bonds are sold at face value, the nominal interest rate and
effective interest rate are the same. Because of the relationship of the premium to the interest,
the bond premium is amortized over the life of the bonds and credited to interest expense.

♦ If the sales price of the bonds is less than the face value, the bonds are said to be
sold at a discount. The bond discount is in effect a loss to the issuing entity. However, it
is not treated as an outright loss. When bonds are sold at a discount, it means that the
buyer or investor is not willing to accept simply the nominal rate of interest. The buyer
wants to accept a rate of interest that is somewhat higher than the nominal rate. Thus,
when the bonds are sold at a discount, the effective rate is higher than the nominal rate.
Accounting wise, the bond discount is amortized as loss over the life of the bonds an
charged to interest expense.

LEARNING ACTIVITIES:

1. Module Quiz - open Quiz 5: Blackboard for Quiz

2. Problem Solving GROUP WORK

BONDS ISSUED AT FACE VALUE ON AN INTEREST DATE

ABC Company’s accounting year ends on December 31. On December 31, 200A, ABC issued 10-year, 12%
bonds with a face value of ₱100,000. The bonds are dated December 31, call for semi-
annual interest payments on June 30 and December 31, and mature in 10 years on

ACT033D – FINANCIAL ACCOUNTING

Editor: Ruben A. San Mateo, CPA, MBA
 Colegio de San Juan de Letran Calamba
Calamba City, Laguna, Philippines

December 31. ABC made the required

interest and principal payments when due.

REQUIRED:
1. Identify the entry to record the issuance of bonds on December 31.
2. Determine the entry to record the payment of interest for June 30.
3. Ten years later, the maturity date, identify the entry for the last payment of interest and the
amount of the bond.

ISSUANCE OF BONDS PAYABLE AT PREMIUM

On January 1, XYZ Company issues ₱100,000, 12% 30year bond for a price of 105.25% with interest to be
paid semi-annually on June 0 and December 31 for cash.

1. How much will be the carrying value, face value, and the premium of the bond?
2. What is the journal entry to record the issuance of bonds?
3. What is the journal entry to record the interest expense on bonds issued at premium?
4. What is the journal entry to record the maturity of bonds issued at premium?

ISSUANCE OF BONDS PAYABLE AT DISCOUNT

On January 1, XYZ Company issues ₱100,000, 12% 30year bond for a price of 95.50% with interest to be
paid semi-annually on June 0 and December 31 for cash.

1. How much will be the carrying value, face value, and the premium of the bond?
2. What is the journal entry to record the issuance of bonds?
3. What is the journal entry to record the interest expense on bonds issued at discount?
4. What is the journal entry to record the maturity of bonds issued at discount

ACT033D – FINANCIAL ACCOUNTING

Editor: Ruben A. San Mateo, CPA, MBA