Summary
Summary Financial Reporting 2 (ACC2012W) - LIABILITIES
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- University Of Cape Town (UCT)
Great summary of all the important concepts involving the Liabilities section.
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LIABILITIESLIABILITY DEFINITION CRITERIA
A liability is a present obligation of the entity to transfer an economic resource as a result
of past events.
A PRESENT OBLIGATION OF THE ENTITY
An obligation is a duty or responsibility that an entity has no practical ability to avoid.
- Having no practical ability to avoid the obligation includes instances where
avoiding the obligation is more costly than settling the obligation.
EXAMPLE: It becomes compulsory for a company to install fire detectors in their buildings
in the next financial year. It is a new law that says you can’t operate unless you have fire
detectors installed. The company hasn’t fitted the fire detectors in by the end of this year.
Question: at the end of this year, is there a liability that needs to be recognized in the financial
statements?
Answer: No, because at the end of the year, the entity can decide to stop operating and then
they won’t have to install the fire detectors, therefore they have no present obligation at year
end. It may then be cheaper to shut down the company than it is to pay the obligation.
Note that simply because one has an obligation, it does not mean
that it is a PRESENT obligation (i.e., the past event has occurred).
An obligation can either be legal or constructive.
- A legal obligation arises through legislation or a contract.
- A constructive obligation arises through past practice that instills an expectation
to transfer economic resources in another party.
An obligation is always owed to another person or entity. However, just because one entity
has an obligation (and therefore a liability), does not mean that the other entity has to
recognise an asset. The recognition criteria must be met.
One could still practically avoid an obligation even if there is merely
an intention and/or likelihood of transfer.
TO TRANSFER AN ECONOMIC RESOURCE
The obligation must have the potential to require the entity to transfer an economic
resource to another party.
- We are giving up the right to something that has the potential to produce economic
benefits.
, Obligations to transfer economic resources include:
- obligations to pay cash
- obligations to deliver goods
- obligations to provide services
- etc.
“Potential” means that the transfer of EBs does not have to be certain or even likely: the
obligation must merely have the potential to require the entity to transfer benefits “in at
least one circumstance”.
AS A RESULT OF PAST EVENTS
The event that leads to the obligation being present (known as the obligating event) is in
the past.
In order for there to be a present obligation, or for the past event to have occurred, the
following must have happened:
a. The entity has already obtained economic benefits or taken an action, and
b. As a consequence, the entity will or may have to transfer an economic resource
that it would not otherwise have had to transfer.
Legislation enacted, or policies adopted, are insufficient to create a
present obligation from a past event. The entity needs to obtain
economic benefits, or take action towards the transfer of an
economic resource. The legislation could give rise to an obligation,
but will only be a PRESENT obligation when there is a past event.
HOW TO CONTRACTS AFFECT LIABILITIES?
A contract is just an agreement to do things for each other.
EXAMPLE: Party A agrees to provide Party B with a good and Party B agrees to pay party A
for the good received.
A liability usually arises:
- Not on signing the contract,
- but rather when economic benefits are obtained from the other party (when the
other party performs in terms of the contract)
This could be either Party A giving the goods, in which case Party B has a liability to pay Party
A for the goods received. Or, it could be party B giving the cash to part A, but not having
received the good yet from Party A, which means Party A has a liability to provide party B with
a good.
LIABILITY RECOGNITION CRITERIA
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