Essentials of FA_Chapter 12

8/13/2019 Essentials of FA_Chapter 12

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Essent ia ls of Financial Accoun t ing , Second Edi t ion — ASISH K. BHATTACHARYYA

ESSENTIALS OF FINANCIAL

ACCOUNTING

B Y ASISH K BHATTACHARYYA Second Edition

Chapter 12




Definition

A liability is a present obligation of the entity arising

from past events, the settlement of which is

expected to result in an outflow from the entity of

resources embodying economic benefits.

The entity has no realistic alternative to settling the

obligation.

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Present Obligation

The obligation should exist at the balance sheet

date.

In most situations, it is quite clear whether an obligation

exists at the balance sheet date.

Only in certain situations, for example, in case of a law

suit, the entity has to develop a perspective of the

situation to formulate a view on whether an obligation

exists at the balance sheet date.

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Past Events

Balance sheet presents the financial position of the

entity at the balance sheet date.

It does not present the possible financial position in

future.

Therefore, obligations that might arise in future from

likely future events are not recognised in the balance

sheet.

A past event that leads to the present obligation is

called obligating event .

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Outflow of Resources

A present obligation is recognised as a liability in

the balance sheet only if it is probable that

economic resources embodying economic benefits

will flow out of the entity in settling the obligation

and the management can estimate the amount ofthat outflow.

If it is less than probable that economic resources

embodying economic benefits will flow out of the

entity, the obligation is disclosed under the heading‘Contingent Liability’, unless the possibility of an

outflow of resources embodying economic benefits

is remote.

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Classification of Liabilities

General classification1 / 8 / 2 0 1 4

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Obligations

Legal obligations Constructive

obligations

Contractual Derived from

legislation


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Legal Obligations

Legal obligations are derived from contracts or from

legislation or from other operation of law.

Examples of legal obligation derived from contracts are

loan obtained by the entity and trade payables.

Examples of obligations derived from legislation areincome tax payable and sales tax payable.

Example of obligation derived from other operation of

law is deferred tax liability.

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Constructive Obligation

A constructive obligation is an obligation that

derives from an entity’s actions where:

(a) by an established pattern of past practice, published

policies or a sufficiently specific current statement, the

entity has indicated to other parties that it will acceptcertain responsibilities; and

(b) as a result, the entity has created a valid expectation

on the part of those other parties that it will discharge

those responsibilities.

All constructive obligations ultimately become

contractual obligations.

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Constructive Obligation: Examples

An obligation from specific current statement of the

entity to restore the environment polluted by use of

its product even if not required by law.

The obligation arising from the past practice of

paying ex-gratia payment to retiring employees and

the obligation arising from past practice of the entity

to replace defective products even after the expiry

of the warranty period.

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Financial Liabilities

Principles for the measurement of financial liabilities

differ from those for the measurement of other

liabilities.

A financial liability is a contractual obligation to

deliver cash or other financial asset to another

entity.

Therefore, an obligation that does not arise from a

contractual arrangement is not a financial liability.

Similarly, a liability to deliver goods or services is not afinancial liability.

A constructive obligation is not a financial liability.

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Financial Liabilities (cont.)

Examples of financial liability are loan obtained

from another entity or from public by issuing debt

instruments, trade payables and security deposits

received from contractors.

Advance received from customers, deferred

revenue, obligations to dismantle and site

restoration arising from the installation of an item of

PP&E and obligations arising from product warranty

are not financial liabilities. Income tax liability and similar other liabilities are

not financial liabilities.

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MEASUREMENT OF FINANCIAL

LIABILITIES

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Initial Measurement

A financial liability is initially measured at fair value,

adjusted for transaction costs, which are directly

attributable to the acquisition of the liability.

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Fair Value

Fair value is the exit price.

In other words, fair value is the price at which the entity

can exit the liability.

In absence of active markets for financial liabilities,

there is no observable exit price for a liability.

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Fair Value (cont.)

Usually, fair value is the present value calculated

using market perception about the interest rate at

which the entity could borrow the amount from the

market for the same term and with similar

conditions. Therefore, if the entity assumes the financial liability at

market terms and conditions, the fair value of a financial

liability is the transaction price.

The interest rate at which the entity could borrow iscalled incremental borrowing rate.

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Fair Value (cont.)

If the liability is assumed with terms and conditions

which are different from market terms and

conditions, the fair value will be different from the

transaction price.

For example, if an entity receives security deposits

from contractors, which execute long-term projects,

and under the terms and conditions that do not

require the entity to pay any interest on the same,

the fair value should be lower than the transactionprice.

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Incremental Borrowing Rate

Incremental borrowing rate is the rate at which the

entity would be able to borrow the funds received

by it over a similar term, and with a similar security.

Incremental borrowing rate might be different from

the average borrowing rate of the entity.

Incremental borrowing rate depends on the credit

rating of the entity’s bond at the time of issue or the

credit risk of the liability assessed by the lender or

the creditor at the time of assumption of the liabilityby the entity.

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Fair Value Lower Than The Transaction

Price

If the fair value is lower than the transaction price,

the difference between the two is recognised as

income and is presented in the profit and loss

account under the appropriate line item.

The nature of the income should be disclosed.

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Short-term Liabilities

Trade payables and other short-term liabilities are

measured at the transaction price.

However, if the time value of money is material,

those are measured at PV calculated by

discounting cash flows associated with the liability

by the rate of interest at which the entity could

borrow the amount from the market.

The PV is considered to be the fair value of the

liability.

Usually, if the liability is expected to be settled after

six months from the date of the transaction, it is

measured at its present value.

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Subsequent Measurement

Liabilities, other than those held for trading and

derivative instruments, are measured at amortised

cost using the effective interest rate method.

Liabilities held for trading (e.g. borrowing of shares

by a short-seller) and derivative instruments are

measured at fair value. The gain or loss arising

from the change in the fair value is recognised as

profit or loss for the period.

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Illustration 1

On 31 December, 2009, Naina Limited (NL) borrowed

Rs. 100 million from the State Bank of India at the

market rate of interest, which is 12% per annum. Other

terms and conditions of the loan are similar to those

which are normally imposed by financial institutions. The loan is repayable in five equal yearly instalments.

Each instalment is payable at the end of the each year

starting from 31 December, 2010.

Interest is payable at the end of each year starting from 31

December, 2010. NL had paid 0.2% of the loan amount to the bank towards

processing charges.

NL closes its financial year on 31 December.

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Illustration 1: Solution

Effective interest is the rate which equates the

present value of cash outflows to the amount

(Rs. 99.8 million) at which the loan was measured

initially.

Effective interest rate comes to 12.086%.

The transaction cost is subsumed in the effective

interest. Therefore, no separate accounting is required

for the same.

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Illustration 1: Solution (cont.)

Table showing calculations1 / 8 / 2 0 1 4

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Year

(1)

Opening

balance(Rs. m ) (2)

Effective

interest (Rs. m) (2 × .1209 )

(3)

Cash outflow

Principal(Rs. m) (4)

Cash outflow

Interest(Rs. m) (5)

Closing

balance (Rs.m) (2 – 4+ 3 – 5)

(6)

2 010 99.800 12. 062 20 .000 12 . 0 00 79.862

2011 79.862 9. 652 20 .000 9.600 59.914

2012 59.914 7. 241 20 .000 7.2 00 39.956

2013 39.956 4. 829 20 .000 4.8 00 19.985

2014 19.985 2. 415 20 .000 2.4 00 0 Total 36.200 100.000 36.000




Illustration 2

Contractors, who are awarded long-term contract by

Lahar Limited (LL), are required to deposit with the

company 10% of the project value as security deposit.

The company does not pay interest on the security deposit.

On 1 January, 2010, it has obtained security deposit of Rs. 10million from Julia Limited (JL).

It is expected to refund the deposit on 1 January, 2012.

LL closes its financial year on 31 December.

As per the market perception, the incremental borrowing rate

of LL is 12%. The deposit was initially recognised at Rs. 7.972 million,

which is the PV of Rs. 10 million, discounted at 12% p.a.

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The effective interest is 12%.

In the year 2010, interest expense is to berecognised in the profit and loss account atRs. 0.957 million (7.972 × 0.12).

The security deposit would be carried in thebalance sheet as at 31 December, 2010 atRs. 8.929 million (7.972 + 0.957).

In the year 2011, interest expense is to berecognised in the profit and loss account atRs. 1.071 million (8.929 × 0.12).

The security deposit would be carried in thebalance sheet as at 31 December, 2010 atRs. 10.000 million (8.929 + 1.071).

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Illustration 3

On 1 January, 2010, a public sector enterprisereceived a loan of Rs. 1,000 million from thegovernment at an interest rate of 6% per annum.

Interest is payable at the end of each year beginning

from 31 December, 2010. The loan is to be repaid in five equal annual instalments.

Each instalment is to be paid at the end of each yearbeginning from 31 December, 2010.

The entity could borrow the amount from the market atan interest of 12% per annum with similar terms andconditions.

The entity initially recognised the loan at Rs. 860.478million, which is the PV of the loan amount discountedat 12% per annum.

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Effective interest rate is 12% per annum.

The difference between the fair value and the

amount of loan is recognised as government grant.

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Year (1)

Openi ng

balance(Rs. m=million)

(2)

Effective

interest (Rs. m) (2 × .12) (3)

Cash outflow Principal

(Rs. m) (4)

Cash outflow Interest

(Rs. m) (5)

Closing

balance (Rs.

m) (2 - 4+3 - 5) (6)

2010 860.478 103.257 200.000 60.000 703.735

2011 703.735 84.448 200.00 0 48.000 540.184 2012 540.184 64.882 200.000 36.000 369.006

2013 369.006 44.281 200.000 24.000 189.286

2014 189.286 22.714 200.000 12.000 0

Total 319.523 1000.000 180.000




PROVISION

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Definition

A provision is a liability of uncertain timing oramount.

Examples of provision are:

Provision for income tax liability

provision for product warranty provision for dismantling of assets and environment

restoration

Provision for post-retirement employee benefits andprovision for disputed claim by customers

Provision for disputed claim by the revenue departmentof the government.

In India, the term ‘ provision’ is also used to refer tovaluation allowance.

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Provisions and Other Liabilities

Provisions can be distinguished from other liabilitiessuch as trade payables and accruals because there isuncertainty about the timing or amount of the futureexpenditure required in settlement. Trade payables are liabilities to pay for goods or services that

have been received or supplied, and have been invoiced orformally agreed with the supplier.

Accruals are liabilities to pay for goods or services that havebeen received or supplied but have not been paid, invoiced orformally agreed with the supplier, including amounts due toemployees.

It is sometimes necessary to estimate the amount or timing ofaccruals, the uncertainty is generally much less than forprovisions.

Accruals are often reported as part of trade and otherpayables, whereas provisions are reported separately.

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Use of Provision

A provision should be used only for expenditure for

which it was originally recognised.

For example, a provision for ‘product warranty’ should

be used only to meet expenses related to product

warranty.

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Provision: Measurement

A provision is measured at the best estimate of the

expenditure required to settle the obligation as on

the balance sheet date.

The best estimate is the amount that the entity would

rationally pay to settle the obligation at the balancesheet date or to transfer to a third party at that time.

The entity estimates the financial effects of the liability

based on experience and by evaluating available

evidence and expert opinion.

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Provision: Measurement (cont.)

The risk and uncertainties that surround manyevents and circumstances should be taken intoaccount in reaching the best estimate of aprovision.

Similarly, future events that may affect the amountrequired to settle an obligation should beconsidered in estimating the expenditure that will berequired to settle the obligation, provided that thereis sufficient objective evidence that those events

will occur. Gains on expected disposal of assets are not taken into

account in measuring a provision, even if the expecteddisposal is closely linked to the event giving rise to theprovision.

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Provision: Measurement (cont.)

The estimates of outcome and financial effects are

determined by the judgement of the management of

the entity.

Where the provision being measured involves a

large population, the liability is measured at theexpected value, calculated using subjective

probabilities.

Where a single obligation is being measured, the

most likely individual outcome may be the bestestimate of the liability.

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Onerous Contracts

As a general principle, a liability is recognised only

if the obligation arises from one or more past

events.

No provision should be recognised for future

operating losses.

An exception to this rule is the provision for onerous

contracts.

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Onerous Contracts (cont.)

Executory contracts are contracts under which

neither party has performed any of its obligations or

both parties have partially performed their

obligations to an equal extent.

An executory contract is onerous if the unavoidablecosts of meeting the obligations under the contract

exceed the expected economic benefits.

An entity should provide for estimated loss from an

onerous contract.

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Restructuring

IAS-37 defines restructuring as a programme that is

planned and controlled by management, and

materially changes either the scope of a business

undertaken by an entity or changes the manner in

which the business is conducted. Restructuring may involve:

(a) Sale or closer of a line of business

(b) Closer of a location or relocation of business

activities (c) Changes in management structure

(d) Changes the nature or focus of an existing business

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Restructuring: Constructive Obligation

IAS-37 stipulates that a constructive obligation for

restructuring arises when the entity

(a) has drawn a detailed formal plan for the restructuring;

and

(b) has raised a valid expectation among the people orentity affected by the plan that the plan will be carried

out.

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(cont.)

The standard stipulates that the detailed formal

plan for restructuring should identify at least:

(a) The business or part of the business concerned;

(b) The principal location affected;

(c) The location, function and approximate number ofemployees who will be compensated for terminating

their services;

(d) The expenditure that will be undertaken; and

(e) When the plan will be implemented.

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(cont.)

A restructuring plan gives rise to a constructive

obligation when it is communicated to those who

will be affected by it, and its implementation is to

start as soon as possible and to be completed in a

timeframe that makes significant changes to theplan unlikely.

A restructuring provision includes only the direct

expenditure arising from the restructuring.

These should arise necessarily from restructuring andshould not be associated with the ongoing activities of

the entity.

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Reimbursement

An entity should recognise reimbursement as a

separate asset, if and only if, it is virtually certain that

the reimbursement will be received.

The amount recognised for the reimbursement should

not exceed the amount of the provision.

In the profit and loss account, expense relating to a

provision may be presented net of the amount

recognised for a reimbursement.

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Effect of Time Value of Money

IAS-37 stipulates that where the effect of time value

of money is material, the amount of a provision

should be the PV of the estimated expenditure that

will be required to settle the obligation.

The same principle should be applied for measuringliabilities other than financial liabilities.

The discount rate should be a pre-tax rate that

reflects the current market assessments of the time

value of money and the risk specific to the liability.

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OTHER ISSUES

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Contingent Liabilities

In a general sense, all provisions are contingent

because they are uncertain in timing or amount.

However, in contingent liability, the term ‘contingent’

is used for liabilities that are not recognised

because their existence will be confirmed only bythe occurrence or non-occurrence of one or more

uncertain future events not wholly within the control

of the entity.

The term ‘contingent liability’ is also used forliabilities that do not meet the recognition criteria.

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Contingent Liabilities (cont.)

Contingent liabilities are not recognised as liabilitiesbecause they are either:(a) possible obligations, as it has yet to be confirmed whether

the entity has a present obligation that could lead to anoutflow of resources embodying economic benefits; or

(b) present obligations that do not meet the recognition criteria(because either it is not probable that an outflow ofresources embodying economic benefits will be required tosettle the obligation, or a sufficiently reliable estimate of theamount of the obligation cannot be made).

In contrast, provisions are recognised as liabilities

(assuming that a reliable estimate can be made)because they are present obligations and it is probablethat an outflow of resources embodying economicbenefits will be required to settle the obligations.

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Contingent Liabilities (cont.)

Contingent liabilities are disclosed by way of notesbelow the balance sheet.

An entity discloses for each class of contingentliability at the end of the reporting period a brief

description of the nature of the contingent liabilityand, where practicable:(a) an estimate of its financial effect;

(b) an indication of the uncertainties relating to the amountor timing of any outflow; and

(c) the possibility of any reimbursement. Capital commitment, although not a contingent

liability, is disclosed under the heading ‘ContingentLiabilities’.

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Contingent Liabilities: Analyst’s View

Analysts are required to examine contingent liabilities

with care.

An analyst has to form a judgement on whether the

entity has disclosed liabilities for which provisions should

have been recognised in the balance sheet. He/She should examine the relative size of a contingent

liability and its nature to understand whether the

contingent liability is consistent with the nature of

business of the entity and also to assess the risk

associated with the contingent liability.

An analyst should carefully go through the notes to

account and should collect information, to the extent

possible from other sources.

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Post-employment Benefit Plans

Post-employment benefits include:

(a) Retirement benefits, e.g. gratuity and pension

(b) Other benefits, e.g. post-employment life insurance

and post-employment medical care

Post-employment benefit plans are deferredpayment plans.

An employee earns entitlement to those benefits

when he/she renders service.

Entitlement increases with additional service. However after a certain length of service, additional

service does not result in increase in the amount of

post-retirement benefits.

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Post-employment Benefit Plans (cont.)

Post-employment benefit plans are classified into:

(a) Defined contribution plans

(b) Defined benefit plans

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Defined Contribution Plan

A defined contribution plan is one in which theemployer pays a fixed contribution (e.g. 10% ofsalary) into a separate entity or fund and itsobligation is limited to that contribution.

The employer is not required to contribute further ifthe fund does not hold sufficient assets to pay allthe employee benefits relating to employee serviceon the current and prior periods.

In defined contribution plan, the financial risks are

borne by the employee. The amount of benefit depends on the performance of

plan assets.

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Defined Benefit Plan

A defined benefit plan is a post-employment benefitplans other than defined contribution plans.

As the name implies, under a defined benefit plan, thebenefit to employees is defined.

Therefore, under such a plan, the employer has theobligation to provide the agreed benefits to current andformer employees. An example of defined benefit plans is the ‘gratuity scheme’

under which the amount of gratuity payable to an employee isdetermined based on the period of service and last pay

drawn. It is not linked to the contributions by the employer over

the period of employment or on the plan assets’performance.

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Defined Contribution Plan: Measurement

of Liabilities

An enterprise recognises contributions payable as

an expense in the profit and loss account for the

period in which the employee has rendered the

service.

If the amount of contribution paid is less than theamount payable, the difference is recognised as a

liability (accrued expense) in the balance sheet as at the

end of the period.

Similarly, any amount paid in excess of the amount due

is recognised as an asset (prepaid expense) in thebalance sheet as at the end of the period.

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Defined Benefit Plan: Measurement of

Liabilities

Defined benefit plans may be:

(a) Unfunded

(b) Wholly or partly funded by contributions by an

enterprise, and sometimes its employees

When a defined benefit plan is funded, theenterprise contributes to an entity or fund that is

legally separate from the reporting enterprise.

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Liabilities (cont.)

Employee benefits are paid by that entity or from

that fund.

However, the amount payable does not depend on

the financial position and the performance of the

entity or fund. Employee benefits are defined in the plan.

The enterprise, in substance, underwrites the

actuarial and investment risks associated with the

plan.

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Liabilities (cont.)

An enterprise uses actuarial valuation to determine

the present value of defined benefit obligations at

the balance sheet date.

Enterprises use the ‘projected unit credit method’ to

determine the present value of the defined benefitobligations of an enterprise.

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Projected Unit Credit Method

The projected unit credit method considers each

period of service as giving rise to an additional unit

of benefit entitlement and measures each unit

separately to build up the final obligation.

In short, projected unit cost method estimatesobligations for services already rendered by

employees up to the valuation date.

However, in estimating the obligations it makes

many assumption including the assumption aboutthe rate at which benefits will be payable to the

employee.

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Liabilities – Set Off

An enterprise recognises the liability at the present

value of the defined benefit obligation at the

balance sheet date minus the fair value at balance

sheet date of plan assets (if any), out of which the

obligations are to be settled directly.

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Uncovered Pension Liability: Analyst’s

Perspective

In analysing financial statements, uncoveredpension liability is considered as a non-operatingliability.

In restructuring financial statements, the amount is

included in debt and the amount of imputedborrowing cost is added to the borrowing costrecognised in the profit and loss account.

The logic is that had the entity decided to top up theplan asset to match it with the liability, it would have

to borrow the amount. Similarly, if the amount of plan assets exceeds the

amount of the liability, the excess amount isconsidered as a non-operating asset.

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END

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