AE16-IA2 - Module 1

SELF-PACED LEARNING MODULE
COLLEGE DEPARTMENT
MODULE 1
Subject:
INTERMEDIATE ACCOUNTING 2
AISAT COLLEGE – DASMARIÑAS, INC.
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INFORMATION SHEET PR-1.1.1

Unit Accounting
Module LIABILITIES
AE16-IA2 Intermediate Accounting 2 Units: 3 Page |2
“LIABILITIES”
The Revised Conceptual Framework for Financial Reporting provides the following definition of
liabilities:
Liabilities are present obligations of an entity to transfer an economic resource as a result of past
events.
You cannot be held liable for anything that you have no power over. Guilt, shame and blame make no
sense when circumstances are beyond your control.” “You are not a burden to be endured. You are an
asset to be desired, preserved and celebrated.”
Accordingly, the essential characteristics of an accounting liability are:
a. The entity has a present obligation.
An obligation is a duty or responsibility that an entity has no practical ability to avoid. The entity
liable must be identified but it is not necessary that the payee to whom the obligation is owed
be identified.
b. The obligation is to transfer an economic resource.
This is the very heart of the definition of an accounting liability. The economic resource is the
asset that represents a right with a potential to produce economic benefits. Specifically, 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.
This means that the liability is not recognized until it is incurred.
Examples of liabilities
a. The more common types of liabilities include the following:
b. Accounts payable to suppliers for the purchase of goods
c. Amounts withheld from employees for taxes and for contributions to the Social Security
System
d. Accruals for salaries, interest, rent, taxes, product warranties and profit-sharing bonus
e. Cash dividends declared but not paid
f. Deposits and advances from customers
g. Debt obligations for borrowed funds — notes, mortgages and bonds payable
h. Income tax payable
i. Unearned revenue
SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

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1 Meeting MS. MARY JOY F. LABAJO MR. WILBERT A. MAÑUSCA
Subject Teacher School Director
Unit Accounting
Module LIABILITIES

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Measurement of current liabilities
Conceptually, all liabilities are initially measured at present value and subsequently measured at
amortized cost.
However, in practice, current liabilities or short-term obligations are not discounted anymore but
measured, recorded and reported at face amount
The reason is that the discount or the difference between the face amount and the present value is
usually not material and therefore Ignored.
Measurement of noncurrent liabilities
Noncurrent liabilities, for example, bonds payable and noninterest-bearing note payable, are initially
measured at present value and subsequently measured at amortized cost.
If the long-term note payable is interest-bearing, it is initially and subsequently measured at face
amount.
In this case, the face amount is equal to the present value of the note payable.
Current Liabilities
PAS l, paragraph 69, provides that an entity shall classify a liability as current when:
a. The entity expects to settle the liability with the entity's operating cycle.
b. The entity holds the liability primarily for the purpose of trading.
c. The liability is due to be settled within twelve months after the reporting period.
d. The entity does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period,
Noncurrent Liabilities
The term noncurrent liabilities is a residual definition,
All liabilities not classified as current are classified as noncurrent liabilities. Noncurrent liabilities include:
a. Noncurrent portion of long-term debt
b. Finance lease liability
c. Deferred tax liability
d. Long-term obligation to officers e, Long-term deferred revenue
Long-term debt falling due within one year

A liability which is due to be settled within twelve months after the reporting period is classified as
current, even if:
a. The original term was for a period longer than twelve months.
b. An agreement to refinance or to reschedule payment on a long-term basis is completed after
the reporting period and before the financial statements are authorized for
issue.
However, if the refinancing on a long-term basis is completed on or before the end o/ the reporting
period, the refinancing is an adjusting event and therefore the obligation is classified as noncurrent.

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Covenants
Covenants are often attached to borrowing agreements which represent undertakings by the borrower.
These covenants are actually restrictions on the barrower as to undertaking further borrowings, paying
dividends, maintaining specified level of working capital and so forth.
Breach of covenants
Under these covenants, if certain conditions relating to the borrower's financial situation are breached,
the liability becomes payable on demand.
PAS 1, paragraph 74, provides that such a. liability is classified as current even if the lender has agreed,
after the reporting period and before the statements are authorized for issue, not to demand payment
as a consequence of the breach.
This liability is classified as current because at the end of the reporting period, the entity does not have
an unconditional right to defer settlement for at least twelve months after that date.
However, 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 twelve months after that date.
Presentation of current liabilities
Under Paragraph 54 of PAS 1, as a minimum, the face of the statement of financial position shall include
the following line items for current liabilities;
a. Trade and other payables

b. Current provisions
c. Short-term borrowing
d. Current portion of long-term debt e, Current tax liability
The term trade and other payables is a line item for accounts payable, notes payable, accrued interest
on note payable, dividends payable and accrued expenses.
Estimated liabilities
Estimated liabilities are obligations which exist at the end of reporting period although their amount IS
not definite.
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.
But inspite of these circumstances, the existence of the estimated liabilities is valid and unquestioned.
Estimated liabilities are either current or noncurrent in nature.

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Examples include estimated liability for premium, award points, warranties, gift certificates and bonus.
Deferred revenue
Deferred revenue or unearned revenue is income already received but not yet earned.
Deferred revenue may be realizable within one year or in more than one year after the end of the
reporting period.
If the deferred revenue is realizable within one year, it is a current liability.
If the deferred revenue is realizable in more than one year, it is classified as noncurrent liability.
Illustration
An entity sells equipment service contracts agreeing to service equipment for a 2-year period.
Cash receipts from contracts are credited to unearned service revenue and service contract costs are
charged to service contract expense.
Revenue from service contracts is recognized as earned over the service period of the contracts.
The following transactions occur in the first year:
Cash receipts from service contracts sold 1,000,000

Service contract costs paid 500,000
Service contract revenue recognized 800,000
Journal entries for first year
1. To record the cash receipts from service contracts sold:
Cash 1,000,000
Unearned service revenue 1,000,000
2. To record the service contract costs paid:
Service contract expense 500,000

Cash 500,000

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3. To record the service contract revenue recognized:
Unearned service revenue 800,000

Service contract revenue 800,000
Gift certificates payable
Many megamalls, department stores and supermarkets sell gift certificates which are redeemable in
merchandise. The accounting procedures are:
The Philippine Department of Trade and Industry ruled that gift certificates no longer have an
expiration period.
Bonus computation
Large entities often compensate key officers and employees by way of bonus for superior income
realized during the year.
The main purpose of this scheme is to motivate officers and employees by directly relating their well-
being to the success of the entity.

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This compensation plan results in liability that must be measured and reported in the financial
statements. The bonus computation usually has four variations:
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.

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AE16-IA2 Intermediate Accounting 2 Units: 3 P a g e | 10
Refundable deposits
Refundable deposits consist of cash or property received from customers, but which are refundable after
compliance with certain conditions.
The best example of a refundable deposit is the customer deposit required for returnable containers like
bottles. drums, tanks and barrels.
Illustration
A deposit of P 10,000 is required from the customer for returnable containers. The containers cost
P8,000.
Cash 10,000
Containers' deposit 10,000
The containers' deposit account is usually classified as current Liability.
If the customer returns the containers, the deposit is simply refunded.
However, if the customer fails to return the containers, the deposit is considered the sale price of the
containers
The excess of the deposit over the cost of the containers is considered as gain.

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“PREMIUM LIABILITY”
Illustration
An entity manufactures a certain product and sells it at P300 per unit.
A soup bowl is offered to customers on the return of 5 wrappers plus a remittance of P 10.
The bowl costs P50, and it is estimated that 60% of the wrappers will be redeemed.
The data for the first year concerning the premium plan are summarized below.
Sales, 10,000 units at P300 each 3,000,000
Soup bowls purchased, 2,000 units at P50 each 100,000
Wrappers redeemed 4,000

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Cash rebate program

A variation of a premium offer is a cash rebate program which has become common place.
Cash register receipts, bar codes, rebate coupons and other proof of purchase often can be mailed to
the manufacturer for cash rebate.
Like any premium offer, the purpose of the cash rebate program is to stimulate sales.
Accordingly, the estimated amount of the cash rebate should be recognized both as an expense and an
estimated liability in the period of sale.
Illustration
An entity offered P500 cash rebate on a particular model of TV set. The customers must present a rebate
coupon enclosed in every package sold plus the official receipt.
Past experience indicates that 40% of the coupons will be redeemed.
During the current year, the entity sold 4,000 TV sets and total payments to customers amounted to
P450,000.

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Cash discount coupon

Another variation of the premium offer is the cash discount coupon program.
The cash discount coupon program is a popular marketing tool for the purpose of stimulating sales.
Like a premium offer and cash rebate program, an expense and an estimated liability for the expected
cash discount should be recognized in the period of sale.
Illustration
During the current year, an entity inserted in each package sold a coupon offering P300 off the purchase
price of a particular brand of product when the coupon is presented to retailers.
The retailers are reimbursed for the face amount of coupons plus 10% for handling. Previous experience
indicates that 30% of coupons will be redeemed.
During the current year, the entity issued coupons with face amount of P5,000,000 and total payments
to retailers amounted to P1,100,000.

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Customer loyalty program — IFRS 15

Many entities use a customer loyalty program to build brand loyalty, retain their valuable customers and
of course, increase sales volume.
The customer loyalty program is generally designed to reward customers for past purchases and to
provide them with incentives to make further purchases.
If a customer buys goods or services, the entity grants the customer award credits often described as
"points"
The entity can redeem the "points" by distributing to the customer free or discounted goods or services.
A customer loyalty program operates in a variety of ways.
Customers may be required to accumulate a specified minimum number of award credits or “points"
before they can be redeemed.
Measurement
An entity shall account for the award credits as a separately component of the initial sale transaction.
In other words, the granting of award credits is effectively accounted for as a future delivery of goods or
services.
IFRS 15, paragraph 74, provides that an entity shall allocate the transaction price to each performance
obligation identified in a contract on a relative stand-alone selling price basis.
In other words, the fair value of the consideration received with respect to the initial sale shall be
allocated between the award credits and the sale based on relative stand-alone selling price.
The stand-alone selling price is the price at which an entity would sell a promised good or service
separately to a customer.
Recognition
The consideration allocated to the award credits is initially recognized as deferred revenue and
subsequently recognized as revenue when the award credits are redeemed.
The amount of revenue recognized shall be based on the number of award credits that have been
redeemed relative to the total number expected to be redeemed.
The estimated redemption rate is assessed each period. changes in the total number expected to be
redeemed do not affect the total consideration for the award credits.

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Instead, the changes in the total number of award credits expected to be redeemed shall be reflected in
the amount of revenue recognized in the current and future periods.
In other words, the calculation of the revenue to be recognized in any one period is made on a
"cumulative basis in order to reflect the changes in estimate.
Illustration — IFRS 15
An entity, a grocery retailer, operates a customer loyalty program.
The entity grants program members loyalty points when they spend a specified amount on groceries.
Program members can redeem the points for further groceries. The points have no expiry date.
The sales during 2020 amounted to base on stand-alone selling price.
During 2020, the customers earned 10,000 points.
But management expects that 80% or 8,000 of these points will be redeemed.
The stand-alone selling price of each loyalty point is estimated at P 100.
On December 31, 2020, 4,000 points have been redeemed in exchange for groceries.
In 2021, the management revised expectations and now expects that 90% or 9,000 points will be
redeemed altogether.
During 2021, the entity redeemed 4,100 points. In 2022, a further 900 points are redeemed.
Management continues to expect that only 9,000 points will ever be redeemed, meaning, no more
points will be redeemed after 2022.

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Third party operates loyalty program

An entity, a retailer of electrical goods, participates in a customer loyalty program operated by an
airline.
The entity grants program members one air travel point for every P1,000 spent on electrical goods.
Program members can redeem the points for travel with the airline subject to availability. The entity
pays the airline P60 for each point.
During the current year, the entity sold electrical goods for consideration totaling P 4,500,000 based on
stand-alone selling price and granted 5,000 points with stand-alone selling price of
P100 per point

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The entity has fulfilled its obligation by granting the points.
Therefore, revenue from points is recognized when the electrical goods are sold.
“WARRANTY LIABILITY”
Home appliances like television sets, stereo sets, ratio sets, refrigerators and the like are often sold
under guarantee or warranty to provide free repair service or replacement during a specified period if
the products are defective.
Such entity policy may involve significant costs on the part of the entity if the products sold prove to be
defective in the future within the specified period of time.
Recognition of warranty provision

PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial
statements under the following conditions:
a. The entity has a present obligation, legal or constructive, as a result of a past event,
b. It is probable that an outflow of resources embodying economic benefits would be required to settle
the obligation.
c. The amount of the obligation can be measured reliably.
Past event
The past events often referred to as the obligating event, must have occurred.

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The obligating event in this case is the sale of the product which gives rise to a constructive obligation.
Probable outflow resources

The warranty results in an outflow of resources embodying economic benefit in settlement.
It is probable that there will be some claims against the warranty.
Reliable estimate
The amount recognized as the warranty provision should be the best estimate of the expenditure to
settle the present obligation.
Where no reliable estimate can be made, no warranty liability is recognized.
Accounting for warranty
There are two approaches in recording the warranty expense, namely:

a. Accrual approach
b. Expense as incurred approach
Accrual approach
The accrual approach has the soundest theoretical support because it properly matches cost with
revenue.
Following this approach, the estimated warranty cost is recorded as follows:
Warranty expense xx
Estimated warranty liability xx
When actual warranty cost is subsequently incurred and paid, the entry is:

Cash xx
At a certain date, the estimate is reviewed to determine its reasonableness and accuracy. The actual
warranty cost is analyzed to validate the original estimate.

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Any difference between estimate and actual cost is a change in estimate and therefore treated currently
or prospectively, if necessary.
Thus, if the actual cost exceeds the estimate, the difference is charged to warranty expense as follows:
Warranty expense xx
If the actual cost is less than the estimate, the difference is an adjustment to warranty expense as
follows:

Warranty expense xx
Illustration 1:
An entity sells 1,000 units of television sets at P9,000 each for cash. Each television set is under warranty
for one year.
The entity has estimated from past experience that warranty cost will probably average P500 per unit
and that only 60% of the units sold will be returned for repair. The entity incurs P 180,000 for repairs
during the year.

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The statement of financial position at the end of the year would report estimated warranty liability of
P120,000 as a current liability. Income statement for the year would show warranty expense of
P300,000.
If the warranty runs over a period of more than one year, a portion of the estimated Warranty liability
shall be reported as current liability and the remaining portion as noncurrent liability.
In other words, the warranty cost expected to be incurred within one year is classified as current and
the balance as noncurrent.
Expense as incurred approach
The expense as incurred approach is the approach of expensing warranty cost only when actually
incurred.
This approach is justified on the basis of expediency when warranty cost is not very substantial or when
the warranty period is relatively short.
The actual warranty cost of P180,000 is simply recorded by debiting warranty expense and crediting
cash.

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Illustration 2:
An entity sells refrigerators that carry a 2-year warranty against defects. The sales and warranty repairs
are made evenly throughout the year.
Based on past experience, the entity projects an estimated warranty cost as a percentage of sales as
follows:

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Testing the accuracy of warranty liability
On December 31, 2021, the estimated warranty liability account may be analyzed based on the 4% and
10% estimate to determine whether the actual warranty costs approximate the estimate.

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Sales made evenly
To have an easier interpretation or understanding of sales accruing evenly during the year, it is fair to
assume that half of the sales were made on January 1 and the other half on July 1.
Thus, the first contract year under a 2-year warranty of the sales made on January 1, 2020, will be within
January 1, 2020, to December 31, 2020, and the second contract year be within January 1, 2021, to
December 31, 2021.
The first contract year under a 2-year warranty of the sales made on July 1, 2020, will be within July 1,
2020, to June 30, 2021. and the second contract year will be within July 1, 2021, to June 30, 2022.
Computations
If sales and warranty repairs are made evenly during the year, the warranty expense for 2020 and 2021,
and the estimated warranty liability on December 31, 2021, are determined as follows:

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Sale of warranty
A warranty is sometimes sold separately from the product sold.
When products are sold, the customers are entitled to the usual manufacturer's warranty during a
certain period.
However, the seller may offer an "extended warranty" on the product sold but with additional cost.
In such a case, the sale of the product with the usual warranty is recorded separately from the sale of
the extended warranty.
The amount received from the sale of the extended warranty is recognized initially as deferred revenue
and subsequently amortized using straight line over the life of the warranty contract.
However, if costs are expected to be incurred in performing services under the extended warranty
contracts revenue is recognized in proportion to the costs to be incurred annually.
Illustration 3:
An entity sold a product for P3, 000.000. The regular warranty period for the product is two years. The
entity sold an additional warranty of two years at a cost of P60,000. The sale is recorded as:
Cash 3,060,000
Sales 3,000,000
Unearned warranty revenue 60,000

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The extended warranty contract starts only after the expiration of the regular two-year warranty period.
If the costs are incurred evenly, the unearned warranty revenue is amortized at the end of the third year
as:
Unearned warranty revenue 30,000

Warranty revenue (60,000 / 2 years) 30,000
Illustration 4:

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“PROVISION – CONTINGENT LIABILITY”
PROVISION
A provision is an existing liability of uncertain timing or uncertain amount.
The essence of a provision is that there is uncertainty about the timing or amount of the future
expenditure.
It is this uncertainty that distinguishes provision from other liabilities.
The liability definitely exists at the end of 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.
Actually, a provision may be the equivalent of an estimated liability or a loss contingency that is accrued
because it is both probable and measurable.
Present obligation
The present obligation may be legal or constructive. It is fairly clear what a legal obligation is.
A legal obligation is an obligation arising from a contract, legislation or other operation of law.
Recognition of provision
PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial
statements under the following conditions:
a. The entity has a present obligation, legal or constructive, as a result of a past event,
b. It is probable that an outflow of resources embodying economic benefits would be required to
settle the obligation.
c. The amount of the obligation can be measured reliably.
A constructive obligation is an obligation that is derived from an entity's actions where:

a. The entity has indicated to other parties that it will accept certain responsibilities by reason of
an established pattern of past practice, published policy, or a sufficiently specific current
statement.
b. And as a result, the entity has created a valid expectation on the part of other parties
that it will discharge those responsibilities.
Otherwise defined, a constructive obligation exists when the entity from an established pattern of
practice or stated policy has created a valid expectation that it will accept certain responsibilities.
Past event
The past event that leads to a present obligation is called an obligating event.

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An accounting provision cannot be created in anticipation of a future event.
The event must have already occurred which gives rise to the legal or constructive obligation.
An obligating event is an event that creates a legal or constructive obligation because the entity has no
realistic alternative but to settle the obligation created by the event.
This is the case where:
a. The settlement of the obligation can be enforced by laws.

b. The event creates valid expectations on the part of other parties that the entity will
discharge the obligation, as in the case of a constructive obligation.
Probable outflow of economic benefits
For a provision to qualify for recognition, there must be not only a present obligation but also a probable
outflow of resources embodying economic benefits to settle the obligation.
An outflow of resources is regarded as probable if the event is more likely than not to occur, meaning
the probability that the event will occur is greater than the probability that it will not occur.
As a rule of thumb, probable means more than 50% likely or substantially more.
Possible means 50% or less likely to occur.
Remote means 10% or less likely to occur or very slight occurrence.
Reliable estimate
Paragraph 25 of PAS 37 provides that-the use of estimates is an essential part of the preparation of
financial statements and does not undermine their reliability.
This is especially true in the case of provision because by nature, a provision is more uncertain that most
items in the statement of financial position.
The standard suggests that by using a range of possible outcomes, an entity usually would be able to
make an estimate of the obligation that is sufficiently reliable.
Where no reliable estimate can be made, no liability is recognized.
Measurement of provision
The amount recognized as a provision should be the best estimate of the expenditure required to settle
the present obligation at the end of reporting period.

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The best estimate is the amount that an entity would rationally pay to settle the obligation at the end of
reporting period or to transfer it to a third party at that time.
Where a single obligation is being measured, the individual most likely outcome adjusted for the effect
of other possible outcomes may be the best estimate.
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.
Where the provision being measured involves a large population of items, the obligation is estimated by
"weighting" all possible outcomes by their associated possibilities. The name for this statistical method
of estimation is "expected value"
Other measurement considerations

The following items are taken into consideration in recognizing and measuring a provision:
1. Risks and uncertainties
2. Present value of obligation
3. Future events
4. Expected disposal of assets
5. Reimbursements

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6. Changes in provision
7. Use of provision
8. Future operating losses
9. Onerous contract
Risks and uncertainties

The risks and uncertainties that inevitably surround and circumstances shall be taken into account in
reaching the best estimate of a provision.
Risk describes variability of outcome.
A risk adjustment may increase the amount at which a liability is measured.
Present value of obligation
Where the effect of the time value of money is material, the amount of provision shall be the present
value of the expenditure expected to settle the obligation.
The discount rate should be a pretax rate that reflects the current market assessment of the time value
of money and the risk specific to the liability.
The discount rate should not reflect the risk for which cash flow estimates have already been adjusted.
Future events
Future events that affect the amount required to settle an obligation shall be reflected in the amount of
a provision where there is sufficient evidence that they will occur.
Such future events include new legislation and changes in technology.
Expected disposal assets
Gains from expected disposal of assets shall not be taken into account in measuring a provision.
Instead, an entity shall, recognize gain on disposal at the time of the disposition of the assets.
In other words, any cash inflows from disposal are treated separately from the measurement of the
provision.

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Reimbursements
Where some or all of the expenditure required to settle a provision is expected to be reimbursed by
another party, the reimbursement shall be recognized when it is virtually certain that reimbursement
would be received if the entity settles the obligation.
The reimbursement shall be treated as a separate asset and not netted against the estimated liability for
the provision.
The amount of reimbursement shall not exceed the amount of the provision.
However, in the income statement, the expense relating to the provision may be presented net of the
reimbursement.
Changes in provision
Provisions shall be reviewed at every end of the reporting period and adjusted to reflect the current best
estimate.
The provision shall be reversed if it is no longer probable that an outflow of economic benefits would be
required to settle the obligation.
Where discounting is used, the carrying amount of the provision increases each period to reflect the
passage of time.
Use provision
A provision shall be used only for expenditures for which the provision was originally recognized.
For example, a provision for plant dismantlement cannot be used to absorb environmental pollution
claims or Warranty payments.
If an expenditure is charged against a provision that was originally recognized for another purpose, that
would camouflage the impact of two different events, thus distorting financial performance and possibly
constituting financial reporting fraud.
Future operating losses
Provision shall not be recognized for future operating losses.
In other words, a provision for operating losses is not recognized because a past event creating a
present obligation has not occurred.

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However, an expectation of future operating losses is an indication that certain assets may be impaired.
An impairment test for these assets may be necessary.
Onerous contract
If an entity has an onerous contract, the present obligation under the contract shall be recognized and
measured as a provision.
An onerous contract is a contract in which the unavoidable costs of meeting the obligation under the
contract exceed the economic benefits expected to be received under it.
PAS 37, paragraph 68, mandates that the unavoidable costs under a contract represent the "least net
cost of exiting from the contract”.
The lower amount between the cost of fulfilling the contract and the compensation or penalty arising
from failure to fulfill the contract is the least cost of exiting from the contract.
Examples provision
a. Warranties - The best estimate of the warranty cost is recognized as a provision because there is
clear constructive obligation arising from an obligating event which is the sale of the product
with warranty.
b. Environmental contamination — If an entity has an environmental policy such that
other parties would expect the entity to clean up any contamination, or if the entity
has broken current environmental legislation, then a provision for environmental
damage shall be made.
The obligating event is the contamination of the property which gives rise to constructive or
legal obligation. A provision is recognized for the best estimate of the cost of cleaning up the
contamination.
c. Decommissioning or abandonment costs — When an oil entity initially purchases an oil field, it
is put under a legal obligation to decommission the site at the end of its life. The costs of
abandonment or decommissioning shall be recognized as a provision and may be capitalized as
cost of the oil field.
d. Court case — After a wedding in the current year, ten people died possibly as a result of
food poisoning from products sold by the entity. Legal proceedings are started seeking
damages from the entity.
When the entity prepares the financial statements for the current years the lawyers advise that
owing to the developments in the case, it is probable that the entity would be found liable. A
provision is recognized for the best estimate of the damages because there is a present
obligation.

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e. Guarantee — In the current year, an entity gives a guarantee of certain borrowings of another
entity. During the years the financial condition of the borrower deteriorates and at year-end, the
borrower files a petition for bankruptcy.
A provision is recognized for the best estimate of the guaranteed obligation because there is
legal obligation arising from the obligating event which is the guarantee.
Restructuring
PAS 37, paragraph 10, defines restructuring as a "program that is planned and controlled by
management and materially changes either the scope of a business of an entity or the manner in which
that business is conducted."
Events that may qualify as restructuring include:

a. Sale or termination of a line of business.
b. Closure of business location in a region or relocation of business activities from one
location to another or relocation of headquarters from one country to another,
c. Change in management structure, such as elimination of a layer of management or
making all functional units autonomous.
d. Fundamental reorganization of an entity that has a material and significant impact on its
operations.
Provision for restructuring
Recognition of the provision for restructuring is required because a constructive obligation may arise
from the decision to restructure.
A constructive obligation for restructuring arises when two conditions are present:
1. The entity has a detailed formal plan for the restructuring which includes the following:
a. The business being restructured.
b. The principal location affected.
c. The location, function and approximate number of employees who will be
compensated for terminating their employment.
d. Date when the plan will be implemented.
e. The expenditures that will be undertaken.
2. The entity has raised valid expectation in the minds of those affected that the entity will carry out the
restructuring by starting to implement the plan and announcing the main features to those affected by
it.

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Illustration
The board of directors of an entity at their meeting held at the current year-end decided to close down
all its international branches and shift its international operations and consolidate them with its
domestic operations.
A detailed formal plan for winding up the international operations was also formalized and agreed by
the board of directors in that meeting.
Letters were sent out to customers, suppliers, workers thereafter. Meetings were called to discuss the
features of the formal plan to wind up international operations and representatives of all interested
parties were present in those meetings.
Amount of restructuring provision
A restructuring provision shall include only direct expenditures arising from the restructuring.
These expenditures are necessarily incurred for the restructuring and not associated with the ongoing
activities of the entity.
For example, salaries and benefits of employees to be incurred after operations cease and that are
associated with the closure of the operations shall be included in the amount of the restructuring
provision.
PAS 37, paragraph 81, specifically excludes the following expenditures from the restructuring provision:
a. Cost of retraining or relocating continuing staff.
b. Marketing or advertising program to promote the new company image.
c. Investment in new system and distribution network.
Such expenditures are categorically disallowed as restructuring provisions because these are considered
to be expenses relating to the future conduct of the business of the entity, and thus are not liabilities
relating to the restructuring program.
Contingent liability
PAS 37, paragraph 10, defines a contingent liability in two ways:
A contingent liability is a possible obligation that arises from past event and whose existence will be
confirmed only by the occurrence or nonoccurrence of one or more Uncertain future events not wholly
within the control of the entity,

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A contingent liability is a present obligation that arises 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.
Contingent liability and provision
The second definition states that a contingent liability is a present obligation.
However, the present obligation is either probable or measurable but not to be considered a 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.
Treatment of contingent liability
A contingent liability shall not be recognized in the financial statements but shall be disclosed only. The
required disclosures are:
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.
d. Possibility of any reimbursement.
If a contingent liability is remote, no disclosure is necessary.
Contingent asset
PAS 37, paragraph 10, provides the following definition:
A contingent asset is a possible asset that arises from past event and whose existence will be confirmed
only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the
control of the entity.
A contingent asset shall not be recognized because this may result to recognition of income that may
never be realized.
However, when the realization of income is virtually certain, the related asset is no longer contingent
asset, and its recognition is appropriate.
A contingent asset is only disclosed when it is probable.
The disclosure includes a brief description of the contingent asset and an estimate of its financial effects.
If contingent asset is only possible or remote, no disclosure required.

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Decommissioning liability
A decommissioning liability is an obligation to dismantle remove and restore an item of property, plant
and equipment as required by law or contract.
A decommissioning liability is also called asset retirement obligation.

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Settlement of decommissioning liability
On December 31, 2029, after 10 years, the entity contracted with another entity to dismantle and
remove the drilling platform for P5,500,000.
The journal entry to record the settlement of the decommissioning liability is:
Decommissioning liability 5,000,000

Loss on settlement of decommissioning
liability 500,000
Cash 5,500,000
On January 1, 2020, the decommissioning liability is P 1,610,000. This amount plus 12% interest
compounded annually will build up to P5,000,000 after 10 years on December 31, 2029.
Thus, the decommissioning liability is debited at P5,000,000.
The journal entry to derecognize the carrying amount of the drilling platform on December 31, 2029 is:
Accumulated depreciation 26,610,000

Drilling platform 26,610,000
Change in decommissioning liability
Under IFRIC 1, changes in the measurement of an existing decommissioning liability shall be accounted
for as follows:
1. A decrease in the liability is deducted from the cost of the asset.
If the decrease in liability exceeds the carrying amount, the excess is recognized in profit or
loss.
2. An increase in liability is added to the cost at the asset.
However, the entity shall consider whether this is an indication that the carrying amount of the asset
may not be fully recoverable.
If there is such an indication, the asset should be tested for impairment.
Illustration
On January 1, 2020, the plant of Seaoil Company is 10 years old. The cost of the plant is P 12,000,000
with accumulated depreciation of P4,000,000.

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The plant has a useful life of 30 years and was depreciated using the straight line with no residual value.
Because of the unwinding discount of 6% over 10 years, the decommissioning liability has grown from
P 1,000,000 to P1,790,000.
On January 1 , 2020, the discount rate has not changed.
However, the entity has estimated that as a result of technological advances, the net present value of
the decommissioning liability has decreased by P800,000.
Journal entries for 2020
Jan. 1 Decommissioning liability 800,000

Plant asset 800,000
Dec. 31 Depreciation 360,000

Accumulated depreciation 360,000
Cost of plant 12,000,000

Reduction of decommissioning liability ( 800,000)
Net cost 11,200,000
Accumulated depreciation (4,000,000)
Carrying amount 7,200,000
Depreciation for 2020 (7,200,000/20years) 360,000
31 Interest Expense 59,400

Decommissioning liability 59,400
Decommissioning liability - January 1, 2020 1,790,000

Reduction (800,000)
Adjusted carrying amount - January 1, 2020 990,000
Interest expense for 2020 (6% x 990,000) 59,400

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“BONDS PAYABLE”
DEFINITION OF BOND
Whenever funds being borrowed can be obtained from a small number of sources, mortgages or notes
are usually used.
However, when large amounts are needed, an entity may have to borrow from the general investing
public through the use of a bond issue.
Bonds are used primarily by corporations and government units.
A bond is a formal unconditional promise, made under seal, to pay a specified sum of money at a
determinable future date, and to make periodic interest payment at a stated rate until the principal sum
is paid.
In simple language, a bond is a contract of debt whereby one party called the issuer borrows funds from
another party called the investor.
A bond is evidenced by a certificate and the contractual agreement between the issuer and investor is
contained in a document known as "bond indenture".
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.
Collateral trust bonds are bonds secured by shares and bonds of other corporation.
Debenture bonds are unsecured or bonds without collateral security.

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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 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.
Other types of bonds
Convertible bonds are bonds that can be exchanged for shares of the 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
Junk bonds are high-risk, high-yield bonds issued by entities that are heavily indebted or otherwise in
weak financial condition.
Zero-coupon bonds are bonds that pay no interest, but the bonds offer a return in the form of a "deep
discount” or huge discount from the face amount.
Features of bond issue

a. A bond indenture or deed of trust is the document which shows in detail the terms of the loan
and the rights and duties of the borrower and other parties to the contract.
b. Bond certificates are used. Each bond certificate represents a portion of the total loan.
The usual minimum denomination in business practice is P 1,000, although smaller
denominations may be issued occasionally.
c. If property is pledged as security for the loan, a trustee is named to hold title to the property
serving as security. The trustee acts as the representative of the bondholders and is usually a
bank or trust entity.

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d. A bank or trust entity is usually appointed as registrar or disbursing agent. The borrower
deposits interest and principal payments with the disbursing agent, who then distributes the
funds to the bondholders.
Contents of bond indenture
The bond indenture is the contract between the bondholders and the borrower or issuing entity-
Normally, the bond indenture contains the following items:
a. Characteristics of the bonds
b. Maturity date and provision for repayment
c. Period of grace allowed to issuing entity
d. Establishment of a sinking fund and the periodic deposit therein.
e. Deposit to cover interest payments
f. Provisions affecting mortgaged property, such as taxes, insurance coverage, collection of
interest or dividends on collaterals
g. Access to corporate books and records of trustee
h. Certification of bonds by trustee
i. Required debt to equity ratio
j. Minimum working capital to be maintained, if any.
Sale of bonds
The bonds needed for the issuance of bonds are usually too large for one buyer to pay. Thus, very often,
the bonds are divided into various denominations of say P 100, P1,000, P 10,000, thus enabling more
than one buyer or investor to purchase the bonds.
Quite often, however, instead of selling bonds of various denominations, the bonds are sold in equal
denominations of say P 1,000 only. The P 1,000 denomination is called the face amount of the bonds.
Each bond is evidenced by a certificate called a bond certificate.
Thus, if bonds with face amount of P50,000,000 are sold, divided into P1,000 denomination, there shall
be 50,000 bond certificates containing a face amount of P 1,000.
When an entity sells a bond issue, it undertakes to pay the face amount of the bond issue on maturity
date and the periodic interest.
Interest is usually payable semiannually or every six months as follows:

a. January 1 and July 1
b. February 1 and August 1
c. March 1 and September 1
d. April 1 and October 1
e. May 1 and November 1
f. June 1 and December 1
Of course, there are certain bonds that pay interest annually or at the end of every bond year.

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Initial measurement of bonds payable

PFRS 9, paragraph 5.1.1, provides that bonds payable not designated at fair value through profit or loss
shall be measured initially at fair value minus transaction costs that are directly attributable to the issue
of the bonds payable.
The fair value of the bond's payable is equal to the present value of the future cash payments to settle
the bond liability.
Bond issue costs shall be deducted from the fair value or issue price of the bonds payable in measuring
initially the bonds payable.
However, if the bonds are designated and accounted for "at fair value through profit or loss", the bond
issue costs are treated as expense immediately.
Actually, the fair value of the bond's payable is the same as the issue price or net proceeds from the
issue of the bonds, excluding accrued interest.
Subsequent measurement of bonds payable

PFRS 9, paragraph 5.3.1, provides that after initial recognition, bonds payable shall be measured either:
a. At amortized cost, using the effective interest method
b. At fair value through profit or loss
Amortized cost of bonds payable

The amortized cost of bonds payable is the amount at which the bond liability is measured initially minus
principal repayment, plus or minus the cumulative amortization using the effective interest method of
any difference between the face amount and present value of the bonds payable.
Actually, the difference between the face amount and present value is either discount or premium on
the issue of the bonds payable.
Accounting for issuance of bonds

There are two approaches in accounting for the authorization and issuance of bonds, namely:
a. Memorandum approach
b. Journal entry approach
Illustration
On January 1, 2020, an entity is authorized to issue 10-year: 12% bonds with face amount of P5,000,000,
interest payable January 1 and July 1, consisting of 5,000 units of P1,000 face amount. The bonds are
sold at face amount to an underwriter.

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Memorandum approach
The following memorandum entry is made in the general journal and a notation of the amount
authorized:
On January 1, 2020, the entity is authorized to issue P5,000,000 face amount, 10-year 12% bonds,
interest
payable January 1 and July 1, consisting of 5,000 units of P 1,000 face amount.
To record the sale of the bonds at face amount:

Cash 5,000,000
Bonds payable 5,000,000
In the succeeding discussions, the memorandum approach of accounting for bonds will be employed, as
this is the one generally followed.
Journal entry approach

To record the authorization of the bonds:
Unissued bonds payable 5,000,000
Authorized bonds payable 5,000,000
To record the sale of the bonds at face amount:
Cash 5,000,000
Unissued bonds payable 5,000,000
Issuance of bonds at a premium

If the sales price is more than the face amount of the bonds, the bonds are said to be sold at a premium.
For example, an entity issued bonds with face amount of P5,000,000 at 105. The quoted price of 105
means "105% of the face amount of the bonds." Thus, the sales price is P5,250,000, computed by
multiplying 105% by P5,000,000.
Journal entry
Cash 5,250,000
Premium on bonds payable 250,000
The bond premium is in effect a gain on the part of the issuing entity because it receives more than what
it is obligated to pay under the terms of the bond issue. The obligation of the issuing entity is limited
only to the face amount of the bonds.
The bond premium however is not reported as an outright gain. When the bonds are sold at a premium,
it means that the investor or the 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 rate of interest.
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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.
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.
Accordingly, if the bonds have a 10-year life and the straight-line method is used for simplicity, the entry
to record the amortization of the bond premium is:

Interest expense (250,000 / 10 years) 25,000
Issuance of bonds at a discount

If the sales price of the bonds is less than the face amount, the bonds are said to be sold at a discount.
For example, an entity issued bonds with face amount of P5,000,000 at 95.
Journal entry
Cash (5,000,000 x 95%) 4,750,000
Discount on bonds payable 250,000
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 bonds are issued 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 and charged to
interest expense.
Thus, if the bonds have a life of 10 years and the straight-line method is used, the journal entry to record
the amortization of the bond discount is:
Interest expense (250,000/10 years) 25,000

Discount on bonds payable 25,000

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Presentation of discount and premium

Discount on bond payable and premium on bond payable are reported as adjustments to the bond
liability account.
The discount on bond payable is a deduction from the bond payable and the premium on bond payable is
an addition to the bond payable.
This treatment is on the theory that the discount represents an amount that the issuer cannot borrow
because of interest differences, and the premium represents an amount in excess of face amount that
the issuer is able to borrow.
The discount on bonds payable and the premium on bonds payable shall not be considered separate
from the bonds payable account. Both accounts shall be treated consistently as valuation accounts of
the bond liability.
Observe the following presentation in the statement of financial position.
Noncurrent liabilities:
Discount on bonds payable (250,000) 4,750,000
and
Noncurrent liabilities:
Premium on bonds payable 250,000 5,250,000
Bond issue costs

Bond issue costs are transaction costs directly attributable to the issue of bonds payable.
Such costs include printing and engraving cost, legal and accounting fee, registration fee with regulatory
authorities, commission paid to agents and underwriters and other similar charges.
Under PFRS 9, bond issue costs shall be deducted from the fair value or issue price of bonds payable in
measuring initially the bonds payable.
Under the effective interest method of amortization, the bond issue cost must be "lumped" with the
discount on bonds payable and "netted" against the premium on bonds payable.
However, if the bonds are measured at fair value through profit or loss, the bond issue costs are
expensed immediately.

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Recording interest on bonds

Accounting for interest expense on bonds requires recognition of two items, namely:
a. Payment of interest during the year

b. Accrual of interest at the end of the year
Illustration
On March 1, 2020, an entity sold bonds with face amount and 12% interest payable semiannually on
March I and September 1.
In as much as the bonds are sold on March 1, 2020, the first payment of interest will be on September 1,
2020.

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Unit Accounting
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Issuance of bonds on interest date

On June 1, 2020, an entity issued bonds with face amount of P5,000,000 at 97.
The bonds mature in 5 years and pay 12% interest semiannually on June 1 and December 1.
The straight-line method is used for simplicity in amortizing discount on bonds payable.
The amortization of the bond discount or premium may be on every interest date or at the end of every
year.
In the given example, the amortization re made at the end of the year.

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If a statement of financial position is prepared on December 31, 2021, the accrued interest payable of
P50,000 is classified as current liability.
The bonds payable should be classified as noncurrent liability:

Discount on bonds payable (102,500)
Carrying amount 4,897,500

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Note that if the bonds are issued between interest dates, an accrued interest is involved.
Normally, when bonds are issued between interest dates, the accrued interest is paid by the buyer or
investor.
The accrued interest on the date of sale for 3 months from January 1 to April 1, 2020, is paid by the
investor because on July 1, 2020, three months after the sale, the investor is going to receive interest for
6 months from January 1 to July 1, 2020.
The accrued interest "sold" is credited to interest expense.
On July 1, 2020, the journal entry to record the payment of semiannual interest is:
Interest expense (5,000,000 x 12% x 1/ 2) 300,000

Cash 300,000
Note that if at this point the interest expense account is posted, it has a debit balance of P150,000 which
represents the correct amount of interest expense from April 1 to July 1, 2020.

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Another approach for the interest accrued

Another approach is to credit the accrued interest on the date of sale to accrued interest payable
account.
Cash 5,378,000
Bonds payable 5,000 000
Accrued Interest payable 150,000
The payment of first semiannual interest is recorded as:
Accrued interest payable 150,000

Interest expense 150,000
Cash 300,000
In either approach, the debit balance of the interest expense account must be P 150,000, the correct
interest expense.
The approach of crediting interest expense instead of accrued interest payable is preferable.
Continuing the illustration, on December 31, 2020, the adjusting entries are:
a. Interest expense 300,000

Accrued interest payable 300,000
Interest accrued for 6 months from
July 1 to December 31, 2020
b. Premium on bonds payable 36,000

Interest expense 36,000
Original life of bonds (5 years x 12) 60 months

Less: Expired life on the date of sale
(January 1 to April 1) 3 months
Remaining life of bonds 57 months
Monthly amortization (228,000/57 months) 4,000

Amortization for 9 months from
April 1 to December 31, 2020 (4,000 x 9) 36,000
The straight-line method is used in amortizing the premium on bonds payable for simplicity.

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Module LIABILITIES
Bond retirement on maturity date
To make a bond issue more attractive, an entity may agree in the bond indenture to establish a sinking
fund exclusively for use in retiring the bonds at maturity.
The periodic cash deposits plus the interest earned on sinking fund securities should cause the fund to
approximately equal the amount of bond issue on maturity date.
When the bonds approach maturity date, the trustee sells the securities and uses the sinking fund cash
to pay the bondholders. Any excess cash is returned to the issuing entity.

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SELF-PACED LEARNING MODULE

AISAT COLLEGE – DASMARIÑAS, INC.

INFORMATION SHEET PR-1.1.1

Accordingly, the essential characteristics of an accounting liability are:

a. The entity has a present obligation.

b. The obligation is to transfer an economic resource.

c. The liability arises from a past event.

This means that the liability is not recognized until it is incurred.

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

Measurement of current liabilities

Measurement of noncurrent liabilities

Long-term debt falling due within one year

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

Presentation of current liabilities

a. Trade and other payables

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

If the deferred revenue is realizable within one year, it is a current liability.

Cash receipts from service contracts sold 1,000,000

Journal entries for first year

1. To record the cash receipts from service contracts sold:

2. To record the service contract costs paid:

Service contract expense 500,000

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

3. To record the service contract revenue recognized:

Unearned service revenue 800,000

Gift certificates payable

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

The containers' deposit account is usually classified as current Liability.

If the customer returns the containers, the deposit is simply refunded.

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

INFORMATION SHEET PR-1.1.1

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

Cash rebate program

Past experience indicates that 40% of the coupons will be redeemed.

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

Cash discount coupon

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

Customer loyalty program — IFRS 15

A customer loyalty program operates in a variety of ways.

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

The sales during 2020 amounted to base on stand-alone selling price.

During 2020, the customers earned 10,000 points.

The stand-alone selling price of each loyalty point is estimated at P 100.

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

Third party operates loyalty program

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

The entity has fulfilled its obligation by granting the points.

INFORMATION SHEET PR-1.1.1

Recognition of warranty provision

SUBJECT TEACHER: APPROVED FOR IMPLEMENTATION:

Probable outflow resources

It is probable that there will be some claims against the warranty.

Where no reliable estimate can be made, no warranty liability is recognized.