Discuss liabilities and the problems of measurement in the context of the present IASB framework.
What are liabilities?
• The definition is broken into parts
• Present obligation
• To pay to an external party
• This obligation is due to happening of a certain past event
• When the obligation will be fulfilled, it will result in an outflow of economic resources
• This obligation has provided certain economic benefit in the past or the benefit is in continuation
Certain things are required to be kept in mind
1. There should be a present obligation to pay to an external party
2. This obligation is the result of a past event
3. At the end there will be an economic outflow of resources
Let us define present obligation
1.There should be a legal agreement. This agreement can be oral or written
2.This agreement should include that in case if any of the party to the contract will cancel the contract than it will compensate the other party for cancellation
3.The probability that the other party would succeed in any action to secure performance or significant compensation
Types of liabilities
There are different types of liabilities. These are as follows
1. Account payable or creditors which arises due to sale of goods and services
2. Interest payable that has got due or accrued
3. Salaries and wages that has got due or accrued
4. Vested vacation pay or any other kind of compensated absences that has got due or accrued
5. Obligation of employee pension
6. Employee benefits that have been accrued, this includes any accrued termination benefits; & amounts payable under guarantees and indemnities where events and amounts have become certain; & deferred or unearned revenue (where amounts have been received but have not yet met the revenue recognition criteria, such as where there are restrictions on use of resources); & transfer payments payable; & currency issued; & lease obligations related to capital leases; and & borrowings –
7. loan from bank including long term and short term
8. Long term debt
9. Loans and advances payable to other levels of government or government entities
When to recognize liabilities?
There are two conditions to be satisfied in order to recognize the liability in the financial statements:
1. It is certain or one can say probable that in future any outflow of economic resources will be required. Resources are termed as benefits.
2. The liability can be measured accurately and reliably.
What is the difference between commitment and liabilities?
Commitment has intention to give up future economic benefit. The basic difference between liabilities and commitment is “Present Obligation”.
Let us understand with an example
When in a board meeting the directors comes to a conclusion that they need to purchase a machine or need to invest in certain project then this is termed as commitment. They have not created a contract with the supplier. They have just come to a conclusion that they will do it. This is where I said that commitment lacks present obligation. In case the directors enters into a contract with the supplier than it becomes a liability. Commitment is a part of liability.
Measurement of a liability
IASB has provided a more market based valuation. Under this model a firm is required to value a liability at the lowest of the amount that they would pay rationally. They pay, fulfil, or transfer at that particular amount. But this did not give any clear cut idea. There are certain present value techniques to measure liabilities.
1.Expected Loss Technique: Chartered Financial Institute provided its support for an expected value or expected loss technique. This is a means of measuring obligations with uncertain outcomes. CFA supports due to the reason that the expected loss method has the consideration of the impacts of events and losses throughout the life of the contract. They do not support the incurred loss model because it recognizes the loss only when it occurs.
Our view is that an expected loss model should produce liability measurements that are a better reflection of the estimation of pricing assumptions in contracts and the range of possible outcomes related to non-contractual obligations.
2. Risk Margin Method: Under this method the liability is adjusted for risk. The comment letter of CFA indicated that they believed that the liability should be adjusted for risk factor. This is a means of measuring obligations with uncertain outcomes In case if we do not consider the risk factor one cannot reflect the market price. As the market price includes all uncertainties that are inherent in assuming the obligations. But this draft was having a lack of clarity deciding how to calculate and apply risk margins and how to measure risk. In such a case the risk should be specifically ascertained and not to be included into discount rates or estimated cash flows. In case if the risk factors are included in the liabilities then it will be difficult to compare the results of one entity with the other. In certain cases it may lead to inaccurate results.
3. Profit Margin Method: The market based prices includes the profit element for two things. This is a means of measuring obligations with uncertain outcomes One is measuring cost and the other is fulfilling their obligations.
4. Discount Rate: We believe that the expected outflows estimated to fulfil an obligation should be discounted to their present value using rates that reflect the time value of money and risks specific to the liability as specified in the Exposure Draft; however, we commented that the Exposure Draft needs to be more explicit on what the discount rate should incorporate. In our view, the proposed standard should better describe the relationship among the characteristics of the liability including the risk of uncertainty (risk margin and/or market risk premium), the obligor’s own credit risk and the risk-free rate. This is a means of measuring obligations with uncertain outcomes.
There are many definitions of liabilities and the definition to be applied depends on the basis of accounting adopted. There are two basis of accounting one is cash and the other is mercantile. Under the cash basis, liabilities are not recognized so there is no need to provide any kind of meaning or definition to liabilities. Once the entity shifts to accrual or mercantile method of accounting then only then the liabilities are recognized.
Some people are of the view that legally enforceable agreements and obligations specifically resulting from binding contracts are liabilities. This is due to the existence of reciprocality or exchange transactions or as a result of unpaid part of liability under non reciprocal or non exchange transactions. In certain cases like contract made by the government with any third party, the government can change the law and make the contract voidable or void ab initio. The government is the supreme law making body so it is up to the government to do what it likes and to ignore and undo what it does not.
So the liabilities are defined as follows
Present obligation to pay to an external party, this obligation is due to happening of a certain past event, when the obligation will be fulfilled, it will result in an outflow of economic resources. This obligation has provided certain economic benefit in the past or the benefit is in continuation. Certain things are required to be kept in minds which are; there should be a present obligation to pay to an external party and this obligation is the result of a past event. At the end there will be an economic outflow of resources.
Ernst & Young. 2009. FASB issues proposal on measurement of liabilities at fair value. Reviewed on 28th January 2015. file:///C:/Users/ram/Downloads/hottopic_bb1752_financialinstruments_8may2009.pdf
Exposure Draft. 2010. Financial Liabilities: Classification and Measurement Fair Value Option. Reviewed on 28th January 2015. https://www.ifrs.org/high-level-summaries/documents/snapshotedfairvalueoptionforfinancialliabilities.pdf
CFA Institute. 2010. Measurement of Liabilities under IFRS. Reviewed on 28th January 2015 https://www.cfainstitute.org/ethics/Documents/Research%20Topics%20and%20Positions%20Documents/issue_brief_20100630.pdf
Public Sector Committee. 1995 Accounting for and Reporting Liabilities. 1995. Reviewed on 28th January 2015 https://www.ifac.org/sites/default/files/publications/files/study-6-accounting-for-a.pdf
Standard Chartered Annual Report. 2011. Contingent liabilities and commitments. Reviewed on 28th January 2015. https://reports.standardchartered.com/ar2011/financialstatements/notes41-48/42contingentliabilitiesandcommitments.html