Module 3 liabilities

what’s a liability

presentn obligation of entity to transfer an economic resource as a result of past events

• entity has an obligation

• obligation is to transfer an econ resource

• obligation is a present obligation that exists as a result of past events

accruals concept

we record transaction in the period in which it occurs

= income is recorded when its earned and expenses are recorded when they’re incurred even if resulting cash is received n paid in a different period

prudence concept

preparers of FS should exercise caution when making judgements

what are the recognition criteria

• the transaction meets the definition of one of the elements (Assets, liabilities, equity, income or expenses)

• it is probable that there will be an inflow/outflow of economic benefit

• it can be reliably measured

what can liabilities be split into

either current obligations (payable within normal operating cycle of business eg 12 months

or noncurrent obligations, more long term

lessor

• provides right to use an underlying asset for a period of time in exchange for consideration (also ref to as a ‘supplier’

lessee

obtains right to use underlying asset for a period of time in exchange for consideration (customer)

journal for lessee’s books

Dr right of use asset

Cr lease liability

the debit - disclosed as a separate class of assets within non current assets

the lease liability represents obligation to make regular payments to the lessor

what does IFRS 16 not apply to?

doesn’t apply to

• leases to explore minerals, oils

• leases of biological ssets

• licences of intellectual property

• certain tangible assets

all leases should obey IFRS 16 other than short-term, low value leases

• lessee may elect not to apply IFRS 16 and to expense the lease payments, apportioned over term of the lease

(q will clearly state tha tyou have elected NOT to follow IFRS 16 and will be expensing the lease instead)

• short term of less than 12 months, w no option to purchase

• low value. csset cannot be dep or highly related to another asset

Dr expense

Cr bank

for these short term expensing leases without IFRS 16

how can you tell if a contract is a lease? needs 4 things

a contract is a lease if it conveys the

1. right to control the use of an

2. identified asset (specified asset) for a

3. period of time in exchange for a

4. consideration

in order to control an asset, the entity must have the rights to:

1. obtain substantially all economic benefits from use of the asset

   • econ benefits may be direct/indirect

   • arise from using, holding or subleasing the asset

   • often achieved thru exclusive use of the asset over the lease term

2. direct use of the asset

   • evident if an entity can change how the asset is used during the contract term or the purpose its used for

   • contractual terms n conditions to protect the asset

identified asset meaning

the identified asset is specified in the contract

it is the subject of the lease, for which the right of use has been given

period of time

the period of time or the lease term is defined

• in weeks, months or yrs

or in amount of use eg for forklift to use for 100,000km- estim 3 yrs

consideration

usually a cash amount, paid in instalments

when determining the lease term, it’ll be the length prescribed in the contract for the non-cancellable period of the lease PLUS..

• periods covered by an option to extend the lease, if the lessee is reasonably certain to exercise the option (will add this onto lease term if they’ll use this)

• periods covered by an option to terminate the lease, if the lessee is reasonably certain not to exercise the option

• rent-free periods provided by the lessor to the lessee

in exam, look at length of the lease n whether or not the lessee is intending to take up the option to extend or terminate the lease

• if termination n purchase is cheaper than extending, its assumed that termination n purchase will be exercised

when deciding whether a contract is a lease or not, what 4 items need to be discussed?

right to control, identified asset, period of time n consideration

even if rent free period of a lease, how is this accounted for?

not considered

the total lease amount is considered and SPREAD over TOTAL LEASE TERM

how to recognise the right to use the asset and the obligation to pay regular payments in the FS?

journal:

Dr right of use asset

Cr lease liability

being the capitalisation of right-of-use asset and recognition of lease liability

increasing asset

increasing liability

why can’t you recognise the asset itself as an item of PPE?

cause you don’t own the asset

you own the right to use the asset for the lease term

right-of-use assets are disclosed as a separate class of assets within non-current assets

what does the lease liability represent?

the obligation to make regular payments to the lessor for the duration of the lease term

long term obligation will be a non-current liability and the payments to be made in the next operating cycle will be recognised as a current liability

eg take out lease for 5 yrs

for first yr, the next 4 yrs will be noncurrent , but 1st yr is current

calculating lease liability, what to do if payments are in arrears?

number of years for the annuity factor will be based on the number of payments

but if the payments are made in advance, the FIRST Payment is made on the INCEPTION of the lease, meaning FUTURE PAYMENTS are number of payments MINUS ONE

how do we value the RoU asset? (right of use)

ROU asset is initially measured at cost

comprises of:

initial measurement of lease liability (the asnwer to the arrears/advance figure) (Dr RoUA) (Cr LL)

• + lease payments made at or before commencement of lease (Dr RoUA) (Cr Bank)

• + direct costs of lease eg legal fees (that wouldn’t have occurred if we didnt have lease (Dr RoUA) (Cr bank)

• + estimated dismantling or restoration costs (Dr RoUA) (Cr provisions)

• - incentives or reimbursements received from lessor (Cr RoUA, Dr bank)

= RoU asset

journal entry on initial recognition is for ROU asset:

Dr RoU asset - cost

Dr Bank (incentives or reimbursements)

Cr bank (initial lease payments AND direct costs of lease)

Cr lease liability (calc above)

Cr provision (for dismantling or restoration

being the capitalisation of RoU asset

how would an accountant act unethically when it comes to leases and right of use assets?

leases give rise to a right of use asset and a corresponding lease liability

they could choose not to recognise the asset and related liability and record lease payments as EXPENSES through profit/loss

= understates assets n liabilities n meant SOFP wouldnt accurately reflect comp’s operations

• no asset would be recognised, desp fact that an entity gains economic benefit from its use

• no liability would be recog, desp fact that entity has a present obligation

waht model is used to measure RoU assets?

the cost model

• RoU asset MUST BE DEPRECIATED

  • as lease term progresses, you’re using the asset to generate benefits n so a corresponding depreciation expense must be recognised

cost/estimated useful life:

• shorter of: lease term or useful life

to calc ROu asset measurement, how do you calculat ecost/estimated useful life? )straight line_

shorter of: lease term or useful life

• will always be useful life if

  • lease transfers ownership to the lessee at end of the lease

  • may give rise to a residual value, which the lessee will benefit from on disposal, which must be taken into account

• contracts with ownership transfer at end of the lease are called ‘ hire purchase’ contracts in the UK - USE USEFUL LIFE

• so cost/useful life

when do payments in arrears occur?

on the last day of the payment period

when do payments in advance occur?

on first day of the payment period

what does each lease payment consist of and why is it improtant to know this split

each payment includes capital portion of the lease obligation as well as an interest portion

• need to know the split of the payment into capital, which reduces the liability n interest, which will be expensed as a finance cost

if payment made in advnace, payment will come in first (taken away from (opening balance of lease liability) in table n interest (adding onto balance of lease liability) coming second.

if payment made in arrears, interest comes first (Added onto opening balance) in table with payment coming second (taken away from lease liability)

for payments in arrears, what sthe journal for plus interest

Dr Finance cost

Cr Lease liability

for payments in arrears, whats the journal for - payment (from openin gbalances)

Dr Lease liability

Cr bank

for paymetns in advnace, whats the journal for taking away payment from LL?

Dr Lease liability

Cr bank

for payments in advance, wahts the journal for adding interest?

Dr finance charge

Cr lease liability

non current liability - for both payments in advance and arrears

figure at end of YR1

current liability- double check if diff for arrears

difference between closing balance at end of YR1 and figure at end of YR 2

current liability - payments in advance

• to work out current liability:full payment amount

• non current liability: capital amoutn left in loan before accruing further interest - so balance in yr2 before adding interest

whats a sale-and-leaseback transaction?

to raise funds, sometimes comp may sell their assets n lease them back immediately.

= releases value tied up in the asset immediately due to upfront receipt of cash, w rental payments being made back to the buyer over the term of the lease

lessee and seller in sale-and-leaseback transaction

lessee and seller receives cash lumpsum from selling their assets

sells it to buyer/lessor

adn then leases underlying asset back from buyer/lessor

makes regular payments to buyer/lessor

what does the accounting treatment of sale-and-leaseback transaction depend on?

depends on whether it qualifies as a sale in accord w IFRS 15 or whether it’s a loan, with asset used as security against the loan

In exam, if the lease term is for a small part of the asset’s useful life, do you assume sale or loan?

assume sale has taken place

but if lease term is for the majority of the asset’s useful life, you can assume a sale HAS NOT taken place (keeping asset in book ,recognising loan secured against asset)

if substance of transaction is a sale

youre selling underlying asset n elasing back right ot use the asset for a period of time

building:

proportion retained

RoUa

Dr RoUa

Cr Lease liability

proportion sold/disposed of

gain/loss recognised Dr/Cr to P/L dep on gain/loss (removing asset from SOFP)

Cr PPE

Dr proceeds

steps for initial recognition of a sale-and-leaseback transaction

1) recognise cash proceeds on sale (fair value) (Dr cash)

2) derecognise item of PPE - no longer owned by comp. cant remain in PPE (Cr PPE, reducing asset on sofp)

3) recognise RoU asset (retained portion of the asset) (Dr RoUA)

• orig asset was held at depreciated cost, so retained portion must also be held at cost (carrying amount CA) at date of transaction)

4) recognise lease liability - will be the PV of future lease payments (Cr Lease liability)

5) recognise gain on sold portion of the asset (Dr/Cr gain/loss SPL)

• full gain on sale cannot be recog as only part of the asset was sold, the leased portion was retained.

• 1) determine total gain (FV-CA of underlying asset)

• 2) determine portion relating to sold element (total gain/FV of underlying asset) x (proceeds - lease liability)

journal for initial recog of sale and leaseback transaction

Dr Bank (incr asset) 1

Dr RoU asset - carrying amount (proportion of asset retained)3

Dr PPE accumulated depreciation (CA removed)2

Cr PPE - cost (CA removed)2

CR lease liability 4

Cr gain on sale (balancing figure) 5

in subseuqent periods, youd depreciate RoU asset as per any other RoU asset (over the shorter of the remaining life of the asset, or lease term) n record payments of the lease liability, split into interest n capital repaymnets

depreciation of sale/lease back asset/unwinding lease liability calculation n journal

cost/lease term = depreciation

Dr depreciatio nSPL

Cr RoU - accum depreciation

lease payment calculation for journal

open balance PVFLP (lease payment x annuity factor)

+interest

-payment

= closing balance (PVFLP+interest(applied to PVFLP)-payment)

journal for lease payment

Dr SPL -finance cost (nterest)

Dr liability (lease payment - interest)

Cr bank (lease payment)

what if the substance of a sale-and-leaseback transaction is NOT a sale?

if its not a sale then its merely a financing agreement with the asset as security

we do not derecognise the asset, but recognise a financial liability instead where lease paymnets are deemed to be loan repayments

IFRS 9 will apply n the deemed loan will usually be classified at amortised cost

• accounting will be sim to a loan

ifrs 16 requires disclosures of loans in the SOFP..

• right of use assets are presented separately IN NON-CURRENT ASSETS or included in PPE n separately disclosed in the notes

• lease liability is split between current n non-current portions n separately disclosed under current n non-current liabilities or incl in other liabilities n separately disclosed in the notes

ifrs 16 requires disclosures of loans in the SPLOCI..

• finance charges rel to lease are incl within total finance charges n separately disclosed in the notes

• depreciation or impairment of RoU assets is included in cost of sales, admin or distribution costs with the details being included in the notes

ifrs 16 requires disclosures of loans in the SOCF…

• all cash implications of the lease will be incl in the SOCF, namely interest paid, any initial direct costs of the RoU asset n any repayments of the capital portion of the lease

will be adjustments under operating cash flows for depreciation/impairments to the RoU asset

IFRS 16 requires following disclosure notes..

• deets of any lease contracts or sale-and-leaseback contracts must be incl in disclosure notes.

  • must incl maturity analysis ( NEED TO PREPARE THIS)

  • n enough add. info for users to understand effect of leases on FS

• RoU asset reconciliation from opening to closing balance, per asset class should also be incl (NEED TO PREP THIS)

• deets of lease interest, short term lease expenses n gains/losses on sale n leaseback should also be disclosed

SOFP - ROu ASSETS

RoU assets can be presented separately on the face of the SOFP, as in this example, or included with PPE on the SOFP and disclosed as a separate item in the PPE disclosure note.

The lease liability is both current and non-current. It can be presented separately on the face of the SOFP, as in this example,  or included within Other liabilities and disclosed as a separate item in the Other liabilities disclosure note.

lease on SPLOCI

Interest paid on the lease liability is disclosed along with other interest in “finance charges”.

Depreciation of the RoU asset is included in COS, admin or distribution expenses, depending on the underlying asset use.

lease on SOCF

Depreciation and impairment of the RoU asset will be added back under non-cash operating activities.

The cash implications of leases are:

• Repayments of interest in operating activities
  Payment of direct costs of the lease, in investing activities

• Repayments of the capital portion of the lease in financing activities 

leases in disclosure notes

It is important to tell the users how you accounted for leases.

The breakdown of finance charges expensed to the SPL is important

A reconciliation of the RoU asset, by asset class as well as a maturity analysis are important.  You may have to prepare these.

what is a provision

liabilities with an element of uncertainty n contingent liabilities are liabilities with an even higher degree of uncertainty

an amount set aside by business, recognising liab in SOFP, to cover a probable future expense with an element of uncertainty

eg warranty provision, where history has made it clear that a busienss will have to reimburse customers for damaged/faulty goods but they will not know exactly which customers will return their goods, how many customers will return their goods n how much will need to be refunded unti lcustomers raise complaint

eg where comp sued by other person. comp expects to lsoe case but is unsure how much they’ll be ordered to pay the other party n when payment will take place.

imp that users of FS know about these potential obligations n we must recognise n disclose them in the FS.

can provisiosn be both current n noncurrent liabs?

yes can be both

are contingent liabs recognised in SOFP?

not recognised on SOFP at all, they’re disclosed in a note only bc their valuation is a matter of judgement

IAS 37 tries to set out strict criteria that must be met to recognise a provision but it still remains a subjective matter

exs of provisions

common:

• legal: eg providing for outcome of court case

• warranty: eg rerfunding customers that bought faulty products

• environmental: eg restoring land of quarry once its no longer being sued

asset decommissioning eg demolishing building once no longer in use

major refit/refurbishment - eg changing branding/look

specific provisions:

• future operating losses

• restructuring/reorganisation

• onerous contracts

Certain liabilities are excluded from IAS 37 as they are covered by another standard

• Financial instruments (covered by IFRS 9 in Module 5)

• •

  Income taxes (covered by IAS 12 in Lesson 3 of this module)

• •

  Leases (covered by IFRS 16 in Lesson 1 of this module)

• •

  Employee benefits (covered by IAS 19 in Module 4)

• •

  Insurance contracts (covered by IFRS 17 and outside the scope of your syllabus)

• •

  Contingent considerations in a business combination (covered by IFRS 3 in Module 6)

why are items like accum depreciation n allowance for doubtful debts not covered by IAS 37?

cause they’re not true liabiltieis, but an adjustment to the carrying amount of assets

a liability is.. module 3 lesson 2

a present obligation.. arising from past events

• obligation arising from legal (contractual) / constructive event (expectation through established practice, issued statement etc)

• obligation must relate to PAST event - past event must be indep on entity’s future actions ie future conduct of its business will NOT change fact that obligation exists

to recognise a liability, what must be outflows be?

probable (greater than 50%, more likely than not) and measurable

problem with uncertainty regarding probability of the outflow

is the outflow of benefits probable, possible or unlikely?

problem with uncertainty regarding measurement of the outflow

value may only be determined in the future, when costs are paid out

• eg decommissioning an asset at the end of its life

amounts may be unpredictable

• eg cost of correcting environmental damage

when deciding to calssify a liability, must always ask:

1. is there a present obligation that is legal or constructive

2. is it from a past event, which is independent on future actions

3. is the outflow certain, probable, possible or unliekly? probable is defined as “more likely than not”

4. can u measure the outflow? a reasonable estimate is acceptable

we can classify liabilities into 4 categories:

1. trade payables - recognise in SOFP

2. accruals - recognise in SOFP

3. provisions “liabiltiy of uncertain timing or amount” - recog in SOFP

4. contingent liability “possible liability” - disclose in notes to FS

w certainty incr from 1-4

trade payables - liability

present obligation: yes, purchase invoice creates a legal obligation to pay

past event: yes, acquired goods or services

possibiltiy of outflow: virtually certain

measurement of outflow: known/included in the invoice

very low level of uncertainty

recognise in SOFP

accruals - liability

present obligation: yes, delivery of goods or services creates a legal obligation to pay

past event: yes, goods or services have already been received

possibiltiy of outflow: virtually certain

measurement of outflow: known/reasonably estimated

very low level of uncertainty

recognise in SOFP

provisions “liability of uncertain timing or amount”

present obligation: yes, legal or constructive obligation

past event: yes

possibiltiy of outflow: probable

measurement of outflow: reasonably estimated

moderate level of uncertainty

recognise in SOFP

contingent liability “possible liability”

present obligation from past event?: possible obligation, confirmed by occurance/non-occurence of future events, not wholly within entity’s control

possibiltiy of outflow: possible

measurement of outflow: uncertain

high level of uncertainty

disclose in notes to FS

can liabiliteis be recognised in FS if it doesn’t meet recog criteria?

no, liabilities CAN ONLY BE RECOGNISED IN FS IF IT MEETS THE RECOGNITION CRITERIA

in case of contingent liabilities, THEY DO NOT MEET RECOG CRITERIA = only disclsoed as note to FS and NOT on face of SOFP

what provides guidance as to whether uncertainty results in a provision or contingent liability?

IAS 37

ask urself 1) do i have a present obligation due to an obligating event (past event)? (could be common practice or law)

• if no past event: do nothing bc no obligation

• if yes, have past event, must consider likelihood of having to settle the obligation. ask ourselves how probable is it that i will need to pay.

  • probable: more liekly than not. more than 50% chance

  • if more than 50%, high hance we have obligation eg of payment

• can we put a monetary value on this?

  • if yes, we create a provision = LIABILITY IN FS

  • If we cannot come up w a value then we disclose the obligation as a CONTINGENT LIABILITY but without value - NOTE IN FS, informing users of FS that this is important to know but not probable so we haven’t created a provision for this

• IF obligation possible but not high above 50%, then raise a contingent liability

where there’s a class of simialr items, what to do?

probability for calss shoudl be considered

eg probability of a single vehicle giving rise to a warranty payment may be low but its probable that some vehicels have warranty issues = outflow of resources may be necessary for the whole class of sales

= RECOGNISE PROVISION

journal entry for recognition of a provision

Dr expense

Cr provision

being recognition of a xxx provision

unless provision is specifically related to an asset eg decommissioning costs, in which they will be a debit to the asset cost

ethical considerations in IAS 37

judgement needed in applying it

• provisions can be used to manipulate FS

• common for comps to create ‘big bath’ provisions - large general provisions, unrelated to a specific obligation.

  • making or adding to such provisions had immediate effect of reducing net assets n profits.

  • parts of these proviisons were released, incr net assets n profits for the yr

  • = disguises results in yrs when profits are poor n allows manufactured long-term trend of incrs in profits year on year,

• unethical accountant can do same by concluding a payment is probable when its not and overestimated the size of portions required

what are provisions

liabilities that are uncertain in timing or amount

so judgement is needed when deciding on value of the provision

IAS 37 requires u to calculate bbest estimate of expenditure required to settle the present obligation at end of reporting period

what does best estimate mean

amount company would rationally pay to settle the obligation immediately or to transfer it to a third party

when calc best estimate, what do u need to take into account?

1. past experience of similar transactions

2. independent expert advice

3. events after the reporting period that give us more info reg the provision eg settlement of a court case, after YE

4. proviison is for FUTURE COSTS - expenses already incurred must be ignored

Two measurement techniques are given to us by IAS37, based on the population of items being provided for:

LARGE POPULATION OF SIMILAR ITEMS:

1. use EXPECTED VALUE technique

• all outcomes are estimated n weighed by their probabilities

  • eg warranty provisions

SINGLE ITEM:

1. use MOST LIKELY OUTCOME

• single most likely outcome will be best estimate

• if there’s range of possible outcomes, best estimate will be the weighted avg of all possible outcomes

• eg court case

so if eg there are costs that have alr been incurred, what do u do w them

DEDUCT THEM FROM TOTAL PROVISION as we may only provide for FUTURE COSTS

recognition of current year provisions

journal entry example

Dr SPL warranty expenses

Dr SPL legal expenses

Cr warranty provision

Cr legal provision

when must you discount a provision to PV?

if it has a material effect, u must discount a provision to PV

• DISCOUNT RATE SHOULD BE PRE-TAX n reflect time value of money n risks attached to liability, exl those which have alr been adjusted for in cashflow estimates

• (DR will always be given)

2021 provision recognised at discounted amount

←> between these 8 yrs, discount is unwound n recognised as a finance cost each year.

finance cost = provision b/f x discount rate

2029 expected settlement date (At full value)

provision at end of current year

provision / 1.065 ^12

provision at end of second year

take provision at end of yr 1 x discount rate = eg 700k

provision at end of yr 1 + 700k = provision for second year

change in provision

when a provision changes, it should be adjusted for as a change in estimate, with a prospective adjustment

future events may affect the amoutn required to settle an obligation n they should be taken into account if there’s an objective evidence that they will occur

care should be taken (re changes to provisions):

1) UNWIND provision n recognise the increase as a finance cost

2) calculate NEW PROVISION and recognise THE INCREASE/DECREASE IN THE PROVISION AS A INCR IN EXPENSES / DECREASE IN EXPENSES

journal for provision and revised provision

provision:

Dr SPL - finance charge

Cr provision for environmental damage

being the unwinding of environmental provision

revised provision:

Dr SPL - COS

Cr provision for environmental damage

being change in estimate of environmental provision

what about gains from expected disposal of assets- do u consider them or not when measuring provisions?

DO NOT consider gains from expected disposal of assets when measuring provision cause this goes against prudence concept

if third party is due to reimburse some of the costs eg insurance comp reimbursing some of ur costs, is this recognised?

only recognised if its virtually CERTAIN to occur

if recognised, it must be a SEPARATE ASSET and NOT SET OFF AGAINST PROVISION

howebver net amount may be reflected in the SPL

Climate-related matters may affect liabilities in the financial statements which are accounted for in accordance with IAS 37. For example:

• An entity could be subject to levies imposed by governments for failure to meet climate-related targets or to discourage or encourage specified activities.

• Regulatory requirements may be placed on an entity to remediate environmental damage caused by its operations.

• An entity may decide to decommission its assets more quickly than originally intended resulting in the remeasurement of its liabilities.

specific provision examples

1. future operating losses

2. onerous contracts

3. restructuring provision

what does IAS 37 say about specific provisions ie future operating losses

IAS 37 states no provision can be made for future operating losses

future operating losses do, however, indicate that assets may be impaired, which would be accounted for under IAS 36 impairment of assets

what are onerous contracts (another specific provision)

contract in which the unavoidable csots of fulfilling the contract exceed the economic benefits derived from carrying it out

• usually arises from long-term supply of goods or services

what causes an onerous contract?

1. changes to market conditions eg costs incr in a fixed price contract so that it is now loss making

2. changes to operations eg company no longer requiring a leased asset b4 the end of the contractual lease term

3. climate-related risks resulting in decreased revenue or increased costs, eg fines on high emissions vehicles