PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS EQUITY

Chapter 10
An overview of accounting for liabilities
10.1

10.2

Pursuant to the Framework for the Preparation and Presentation of Financial Statements, for
an item to be characterised as a liability the following attributes should exist:

there must be a probable future sacrifice;

the obligations must be specific to the reporting entity;

the transaction giving rise to the obligation must already have occurred; and

the amount of the obligation and time of its settlement must be measurable with
reasonable accuracy.

Pages 362 to 366 of your text address contingent liabilities. A useful decision tree is provided
on page 364. Paragraph 10 of AASB 137 defines a contingent liability as:
(a) a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will
be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
A contingent liability is therefore considered to exist where there is a possibility that the
reporting entity will be obliged (not currently obliged) to transfer resources in the future as a
result of a future happening, for example, an agreement (such as a guarantee) that has already
been entered into, or the outcome of a future event (such as a legal judgement in a negligence
claim), and the amount is potentially material. As there might be no current obligation (the
obligation is contingent upon a future event), the item would not qualify for inclusion in the
balance sheet. If the probability that a future cash flow will occur is deemed to be remote
then no disclosure is required. A contingent liability is also deemed to exist when there is an
existing obligation, but that obligation cannot be measured with reasonable accuracy. If
something cannot be measured with reasonable accuracy then it will not be included in the
balance sheet.
A contingent liability should be disclosed in the notes to the financial statements. Failure to be
aware of potential and material liabilities that the firm may be subject to can make the
accounts misleading.

10.3

AASB 137 defines a provision as a liability of uncertain timing or amount.

Paragraph 11 states that provisions can be distinguished from other
liabilities such as trade payables and accruals because there is
uncertainty about the timing or amount of the future expenditure
required in settlement. According to paragraph 14 of AASB 137, a
provision shall be recognised when:

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(a) an 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 will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
If these conditions are not met, no provision shall be recognised.
If there is a legal requirement that $15 million must be paid to clean up
the contamination, and if the amount is deemed to be a reliable estimate
of the clean-up costs, then a provision should be recognised. However,
even if there is not a legal obligation then it is possible that there is a
constructive obligation to undertake the clean-up, and a provision would
also be recognised. A constructive obligation is defined in AASB 137 as:
an obligation that derives from an entitys 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 accept certain 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.

10.4

(a)

Provision for repairs

A provision for repairs has traditionally been disclosed as a liability, possibly classified
into current and non-current portions. However, from the perspective of the AASB
Framework, repairs would not qualify as liabilities as they do not involve a present
obligation to an external party. AASB 137 also acts to exclude many provisions from
being classified as liabilities, and indeed, from being shown anywhere within the
financial statements given that many provisions do not create obligations to make
future sacrifices of economic benefits to parties external to the entity.

(b)

Provision for long-service leave

Under generally accepted accounting principles, a provision for long service leave
would be shown as a liability, broken up into current and non-current portions. As a
future obligation exists to an employee (that is, to an external party) which could be
measurable with some accuracy (perhaps using various actuarial assumptions), and it
relates to work performed by the employee in the past, the liability would also be
recognised pursuant to the AASB Framework and other accounting requirements.

(c)

Dividends payable
Dividends payable is an interesting issue. Previously, under generally accepted
accounting principles, a provision for dividends would have been shown as a current
liability at the time they were proposed, rather than subsequently when they were
approved (typically at an annual general meeting held after the balance sheet date).
This was the case even though the reporting entity did not ratify the dividend until the
annual general meeting which is typically held a number of weeks after balance date

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(an after balance date event). This seemed to be a reasonable thing to do if it was
probable that the dividend would be paid at a future date (that is, ratification appeared
a formality), and the dividend did relate to earnings made prior to year end. However,
pursuant to AASB 110 Events After the Balance Sheet Date, a liability for dividends
payable can only be recognised once the ultimate payment has been approved by the
appropriate parties.
(d)

A guarantee for the debts of a subsidiary

Under generally accepted accounting principles this would be classified as a
contingent liability, and if it is potentially material, then it should be disclosed in the
notes to the financial statements. If the guarantee has become enforceable then the
liability would be included in the balance sheet as either a current or non-current
liability. The guarantee would not be classified as a liability for inclusion in the balance
sheet (unless it had become enforceable) as the entity would not be obliged to transfer
resources as at reporting date.

10.5

The issue price of a debenture will equal the face value when the coupon rate on the
debenture is the same as the rate required by the market.
If the market requires a higher rate of return than the coupon rate, then the debentures will be
issued at a discount. The issue price will be reduced sufficiently below par (or face value) so
as to cause the effective rate of return on the income stream, and repayment of the principal,
to be equal to the markets required rate of return.
When the coupon rate is greater than the required market rate, then the issue price will
increase to the point at which the effective rate of return equals the rate of return required by
the market.

10.6

All things being equal, it is generally considered that the higher the level of debt, the higher
the perceived risk of an entity. When an entity issues debt capital it is required to pay interest
periodically as well as the principal at the end of the debt term. Interest payments reduce
reported profits. If something is deemed to be equity then the related payment is a dividend
and dividends are an appropriation of profits and therefore do not reduce profits.
The greater the levels of debt, the greater the cash flow obligations which must be met
regardless of whether the entity is generating profits and/or positive cash flows from its
operations. This can be contrasted with equity capital. For ordinary shares there is no fixed
obligation to pay dividends.
Organisations often enter contractual arrangements which restrict the amount of debt they
can issue, such as debt to asset constraints. When debt levels are high this may be considered
as an indication that the organisation is close to breaching its debt covenants. This could be
viewed in a negative light by the capital market.

10.7

When a new accounting requirement is introduced, for example as a result of a new

Accounting Standard being issued, this may have adverse effects on contractual clauses that
have already been negotiated within debt contracts. At the extreme, the release of new
Accounting Standards may cause a borrowing organisation to be in technical default of
particular contractual clauses (for example, a new Accounting Standard may require that all
items of a specific type which had previously been considered to be assets must be written
off. This in turn may lead to problems relating to particular debt to asset constraints). To

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reduce the problems associated with unanticipated changes to Accounting Standards, an

entity may seek to renegotiate its contracts with the respective lenders.
If the debt issue was made to the public then obtaining the approval for a change to the
contract from a majority of the lenders may be very difficult to achieve. In the case of a
private issue of debt only one party may be involved, and negotiating with this one party may
be much easier.
10.8

This is an argument that is raised on page 371 of the textbook. The counter-argument is that
there are social costs associated with removing the incumbent management team which
warrant consideration in their own right, but that these social costs are typically ignored by
traditional financial accounting practices.

10.9

It is determined by the difference between the present value of the future cash flows
associated with the debenture (interest and principal receipts), and the face value of the
debenture.
The present value of the future cash flows is determined by discounting the interest annuity,
and the principal repayment, at the markets required rate of return.

10.10 Redeemable preference shares

If the preference share provides for mandatory redemption or gives the holder of the share
the right to require the issuer to redeem the instrument on or after a particular date for a
fixed or determinable amount, then the instrument is a financial liability. That is, if the holder
of the preference share has a right to require the issuing company to redeem the preference
share then, regardless of the probability of the redemption, the share would be disclosed as a
liability. This represents a departure from the AASB Framework.
However, if the option for redemption is at the option of the issuer the instrument would not
be considered to represent a liability unless the issuer has notified holders that it intends to
redeem to instruments.
Perpetual convertible notes
Convertible notes can often be considered to be part debt and part equity. AASB 132
Financial Instruments: Disclosure and Presentation notes that to the extent that the holder
of the note has an option to require the company to pay cash to them, then there is a liability
element. There is also an equity element to the extent that the notes can be converted to
shares. Hence, for perpetual convertible notes there will be both a liability and an equity
component. The financial liability component is the contractual obligation to deliver cash and
the equity instrument is a call option granting the holder the right, for a specified period of
time or at a specific date or dates, to convert into equity instruments of the issuer. The
economic effect of issuing such an instrument is substantially the same as issuing
simultaneously a debt instrument and options to purchase equity instruments, or issuing a
debt instrument with detachable equity instrument purchase options. Accordingly, in such
cases, the issuer presents liability and equity elements separately on its balance sheet.
We will not consider how to determine the amounts of the equity and liability components in
this answer (this issue is covered in Chapter 15).
Preference shares
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If the preference shares are not redeemable at the option of the holder and do not provide
for cumulative dividends then they would qualify as equity. On the other hand, if the terms
of a non-redeemable preference share create a contractual obligation of the issuer to pay
cumulative dividends of a fixed amount on determinable dates, that share constitutes a
financial liability, the fair value of which represents the present value of the stream of the
contractually required future dividends. Each preference share issue would need to be
considered individually.
Paragraph AG 26 of AASB 132 states:
When preference shares are non-redeemable, the appropriate classification is
determined by the other rights that attach to them. Classification is based on
an assessment of the substance of the contractual arrangements and the
definitions of a financial liability and an equity instrument. When distributions
to holders of the preference shares, whether cumulative or non-cumulative, are
at the discretion of the issuer, the shares are equity instruments. The
classification of a preference share as an equity instrument or a financial
liability is not affected by, for example:
(a) a history of making distributions;
(b) an intention to make distributions in the future;
(c) a possible negative impact on the price of ordinary shares of the issuer if
distributions are not made (because of restrictions on paying dividends
on the ordinary shares if dividends are not paid on the preference
shares);
(d) the amount of the issuers reserves;
(e) an issuers expectation of a profit or loss for a period; or
(f) an ability or inability of the issuer to influence the amount of its profit or
loss for the period.
Subordinated loans
A subordinated loan is defined as one that is given a lower ranking for repayment than some
or all other debts of the entity. Nevertheless, it ranks above share capital in terms of
repayment on liquidation. Given their preferential repayment terms relative to equity, they
should be treated as debt.
10.11 A provision for warranty repairs would be recorded and disclosed. It is a liability as there
would be a present legal obligation to parties external to the organisation. It would be
disclosed as a provision because the amount and timing of the future sacrifice of economic
benefits that will be made is uncertain. The amount of the provision would be based on the
probability that people would return the boats for repairs, and on the actual costs associated
with the repairs. To the extent that discounting to present values will not be materially
different to the undiscounted value, Brighton Ltd might elect to disclose the liability without
discounting.
10.12 Expectations relating to future refits and refurbishments are not of the nature of liabilities
because there is no present obligation to an external party. No provision would be recognised
at reporting date because no obligation for refurbishment exists independently of the entitys
future actions. The intention to undertake the refit/refurbishment depends upon the entity
deciding to continue using the assets. Rather than recognising a provision, the depreciation
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recognised each period should take account of the consumption of the economic benefits
inherent in the asset. When the refurbishment/refit occurs such expenditure would be
capitalised consistent with AASB 116 Property, Plant and Equipment and then depreciated
over subsequent periods.
10.13 There is a legal obligation enforceable by an external party, and hence a liability in the form of
a provision should be recognised (we would classify it as a provision because the amount and
the timing of the payments are uncertain). Assuming that the restoration work would not be
undertaken for a number of years, then the provision would be disclosed as a non-current
liability. The liability, and the associated expense, should be recognised over the life of the
mine and throughout the operations of the entity and as the work necessitating the
restoration is undertaken. The liability would be discounted back to its present value.
10.14 This really depends upon the intentions and/or business practices of Elwood Ltd. Although
there might be no legal obligation, this does not mean that Elwood will not recognise a
liability, as a constructive obligation might be deemed to exist. A constructive obligation is
defined at paragraph 10 of AASB 137 as:
an obligation that derives from an entitys 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
accept certain 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.
Hence, if the entity has a history of disregarding its responsibilities to the environment and
there is no legal requirement to decontaminate the land, then no liability might be recognised.
However, the organisation might have publicly released policy statements that state that the
organisation takes its environmental responsibilities very seriouslyif so, a constructive
liability might be deemed to exist and disclosure would be appropriate.
10.15 The debt covenant (such as a debt to asset constraint, or an interest coverage clause) may be
based on rolling generally accepted accounting principles, that is, the principles in place at
the time the ratios are calculated. If this is the case, when a new accounting standard is issued
then this will potentially change how certain accounting numbers used with a covenant are
calculated. Many accounting-based contracts will be subject to rolling GAAP given that it is
not possible to pre-specify all accounting methods in advance. When a new Accounting
Standard is issued which prohibits certain methods which had previously been used, this is
considered to represent a change to GAAP.
If a contract relies, at least in part, on rolling GAAP then the release of a new or amended
Accounting Standard may cause changes to the reported assets, liabilities, expenses or
revenues of a reporting entity. To the extent that the affected accounting numbers are used
within particular accounting-based contracts, the new Standards could potentially lead to a
violation of an existing debt covenant.
10.16 Paragraph 32 of AASB 132 states:
The issuer of a bond convertible into ordinary shares first determines the carrying
amount of the liability component by measuring the fair value of a similar liability

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(including any embedded non-equity derivative features) that does not have an
associated equity component. The carrying amount of the equity instrument
represented by the option to convert the instrument into ordinary shares is then
determined by deducting the fair value of the financial liability from the fair value
of the compound financial instrument as a whole.
Hence, we would determine the present value of $20 to be paid in one month and allocate
this to the liability component. The rate of interest to be used would be the markets required
rate of return on a similar debt instrument that does not have the attached equity component.
The balance of the $20 (which would be small) would represent the equity component. If the
equity component is so small as not to be deemed to be material then the whole instrument
could be disclosed as debt.
10.17 In this question, the interest payments of 10% are made each 6 months for 5 years.
Therefore, we will treat the debentures as offering a coupon rate of 5% over 10 periods.
Similarly, the market rate will be calculated as 4% for 10 periods.
(a)

The issue price is equal to the present value of the interest annuity and the principal
repayment. The discount rate is the markets required rate of return, in this case, 4%.
Issue price:

PV of principal = 1 000 000 x 0.6755642 =

PV of annuity = 50 000 x 8.1108957 =

675 564
405 545
1 081 109

Because the market rate is less than the coupon rate of the debentures, the debentures
are issued at a premium as shown above.
(b)

(i)

1 July 2008
Dr
Cr
Cr

Cash
Debenture liability
Debenture premium

1 081 109
1 000 000
81 109

To amortise the premium using the effective-interest method, we may use the
following table. Within the table, the interest expense is determined by
multiplying the opening liability by the required market rate of interest, in this
case, 4% per annum.

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Period
1
2
3
4
5
6
7
8
9
10
(ii)

Interest
expense
43 244
42 974
42 693
42 401
42 097
41 781
41 452
41 110
40 754
40 385

Cash
payment
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000
50 000

Premium
6 756
7 026
7 307
7 599
7 903
8 219
8 548
8 890
9 246
9 615

Closing
liability
1 074 353
1 067 327
1 060 020
1 052 421
1 044 518
1 036 299
1 027 751
1 018 861
1 009 615
1 000 000

30 June 2009 (which is the second 6 month period)

Dr
Dr
Cr

(iii)

Opening
liability
1 081 109
1 074 353
1 067 327
1 060 020
1 052 421
1 044 518
1 036 299
1 027 751
1 018 861
1 009 615

Interest expense
Debenture premium
Cash

42 974
7 026
50 000

30 June 2010 (which is the fourth 6 month period)

Dr
Dr
Cr

Interest expense
Debenture premium
Cash

42 401
7 599
50 000

10.18 In this question, the interest payments of 8% are made each 6 months for 6 years. Therefore,
we will treat the debentures as offering a coupon rate of 4% over 12 periods. Similarly, the
market rate will be calculated as 3% for 12 periods.
(a)

The issue price is equal to the present value of the interest annuity and the principal
repayment. The discount rate is the markets required rate of return: in this case, 4%.
Issue price:

PV of principal = $2 000 000 x 0.7014 =

PV of annuity = $80 000 x 9.9540 =

$1 402 800
796 320
$2 199 120

Because the market rate is less than the coupon rate of the debentures, the debentures
are issued at a premium, as shown above.
(b)

(i)

1 July 2008
Dr
Cr
Cr

Cash
Debenture liability
Debenture premium

2 199 120

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199 120

108

(ii)

30 June 2009
The amortisation of the premium each 6 months would be calculated as
$199,120 12 = $16 593
Dr
Dr
Cr

(iii)

Interest expense
Debenture premium
Cash

63 407
16 593
80 000

30 June 2010
As the straight-line method is being used, the entry will be the same as 30 June
2009.

10.19 In this question, the interest payments of 10% are made each 6 months for 10 years.
Therefore, we will treat the debentures as offering a coupon rate of 5% over 20 periods.
Similarly, the market rate will be calculated as 6% for 20 periods.
(a)

The issue price is equal to the present value of the interest annuity and the principal
repayment. The discount rate is the markets required rate of return, in this case, 6%.
Issue price:

PV of principal = 1 000 000 x 0.31180 =

PV of annuity = 50 000 x 11.46992 =

311 800
573 496
885 296

Because the market rate is more than the coupon rate of the debentures, the
debentures are issued at a discount as shown above.
(b)

(i)

1 July 2008
Dr
Dr
Cr

Cash
Debenture discount
Debenture liability

885 296
114 704
1 000 000

To amortise the premium using the straight-line interest method, we simply

divide the discount by the number of periods. The interest expense in each
period will be the same.
Discount amortisation = 114 704 divided by 20 = 5735.
(ii)

30 June 2009
Dr
Cr
Cr

(iii)

Interest expense
Debenture discount
Cash

55 735
5 735
50 000

30 June 2010
As per 30 June 2009, given that the straight-line method is used.

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10.20 In this question, the interest payments of 8% per annum are made each 6 months for 5 years.
Therefore, we will treat the debentures as offering a coupon rate of 4% over 10 periods.
Similarly, the market rate will be calculated as 5% for 10 periods.
(a)

The issue price is equal to the present value of the interest annuity and the principal
repayment. The discount rate is the markets required rate of return, in this case, 5%.
Issue price:

PV of principal = 5 000 000 x 0.6139 =

PV of annuity = 200 000 x 7.7217 =

3 069 500
1 544 340
4 613 840

Because the market rate is greater than the coupon rate of the debentures, the
debentures are issued at a discount as shown above.
(b)

(i)

1 July 2008
Dr
Dr
Cr

Cash
Debenture discount
Debenture liability

4 613 840
386 160
5 000 000

To amortise the discount using the effective-interest method, we may use the
following table. Within the table, the interest expense is determined by
multiplying the opening liability by the required market rate of interest: in this
case, 5% per annum.
Period
1
2
3
4
5
6
7
8
9
10

Opening
liability
4 613 840
4 644 532
4 676 759
4 710 597
4 746 127
4 783 433
4 822 605
4 863 735
4 906 922
4 952 268

Interest
Cash
expense payment
230 692 200 000
232 227 200 000
233 838 200 000
235 530 200 000
237 306 200 000
239 172 200 000
241 130 200 000
243 187 200 000
245 346 200 000
247 614 200 000

Discount Discount
amortis. balance
30 692 355 468
32 227 323 241
33 838 289 403
35 530 253 873
37 306 216 567
39 172 177 395
41 130 136 265
43 187
93 078
45 346
47 732
47 614
118

Closing
liability
4 644 532
4 676 759
4 710 597
4 746 127
4 783 433
4 822 605
4 863 735
4 906 922
4 952 268
4 999 882*

* the balance should be 5 000 000. The difference is due to using present value
tables which are only to 4 decimal places.
(ii)

30 June 2009 (which is the second 6 month period)

Dr
Cr
Cr

Interest expense
Debenture discount
Cash

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232 227
32 227
200 000

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(iii)

30 June 2010 (which is the forth 6 month period)

Dr
Cr
Cr

Interest expense
Debenture discount
Cash

235 530
35 530
200 000

10.21 Arguably, given the materiality of the financial amounts involved, and the implications for
Coca-Colas reputation, the organisation should have disclosed information about the law suit
in those financial reports that were released following the first time they were aware of the
legal action. Initially, any reference to the law suit would probably be restricted to the notes
to the financial statements given the difficulty involved in assessing the likely payments, and
also because of the contingent nature of the action. Once it becomes probable that a payment
will be made, and that amount can be reliably measured, then the amount should be included
within the liabilities of the entity.
10.22 Given the materiality of the amounts involved, the financial reports released by Fosters
should make some reference to the lawsuit. Whether it is disclosed in the notes as a
contingent liability, or recognised as a liability for inclusion in the statement of financial
position depends on the perceived probability that Fosters will ultimately lose the lawsuit.
There is also the issue as to whether any ultimate payment can be reliably estimated. If they
believe that they will not have to pay, disclosure in the notes is still warranted, and arguably,
some reference should be made to estimates of the amounts potentially involved. A review of
Fosters 2001 annual report shows that the following information pertaining to the lawsuit
was disclosed under a contingent liabilities note. An identical note appeared in the 2000
annual report.
The liquidator of the Emanuel Group of companies has commenced legal action
against several companies in the Group, including FBG Limited. The claims allege
wrong doing in relation to certain financing and related transactions between
Emanuel and the Group. The Group has been advised that the claims should fail.
FBG Limited and the other controlled entities that are party to the action have
denied liability for the claim and are vigorously defending the proceedings.
Students are encouraged to discuss whether they consider that the above note is sufficient to
inform financial statement users about the potential magnitude of any settlement.
10.23 Clearly the action being taken against Pacific Dunlop is financially significant. The issue is
whether this significance, or potential significance, is reflected in the organisations financial
report. Could the readers of the financial report be given an objective appreciation of the
progress of the lawsuits, and the possible implications for the company? This question is
useful to stimulate discussion amongst the students about whether they think the note
disclosure is adequate. Because much professional judgement is involved in determining the
contents of a contingent liability note, there is really no right or wrong answer to this
question. Generally speaking, and in comparison with many other reporting entities, the note
disclosure provided by Pacific Dunlop is fairly reasonable. Perhaps more information about
the probable upper-limit of the associated costs would have been useful, but perhaps the
companys managers would argue that the outcome is too uncertain to try to quantify the
settlement.
What is obvious from reading the Contingent Liability note of Pacific Dunlop is that the
organisation has numerous contingent liabilities, a great deal of which are potentially very
significant. As such amounts are not reflected in the balance sheet, it is imperative that
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financial statement users review the notes for an awareness of additional liabilities that could
potentially become payable.
10.24 A number of issues would be relevant here before deciding how details about the lawsuit of
the Ten subsidiary would be disclosed. Is Eye Corp liable for the payment, or is it a liability of
Mr Nettlefold? What is the probability that the claim will succeed? What is likely to be the
amount of a settlement, if the claim is successful? Given the many uncertainties involved, it
would be unlikely that the company would include any obligations associated with the claim
in its balance sheet. However, to be prudent, the notes to the financial statements should
provide details of the claims, information about the perceived likelihood that the action will
succeed, and, if possible, the estimated amounts and timing of any settlement. Where there is
uncertainty, the company could elect to provide a range of possible settlement amounts.
10.25 The whole issue associated with the establishment of a separate entity to take responsibility
for the obligations of another entity is interesting. The actions of James Hardie and its
apparently under-funded compensation fund attracted a great deal of attention throughout
2004 and 2005. By James Hardies actions it does appear to have accepted responsibility for
the health impacts caused by the production of its products. Given this apparent acceptance,
and given the argument that the compensation fund has insufficient funds to meet future
obligations, then it would be appropriate for James Hardie to make some form of disclosure
in its annual report. Because the additional amounts to be paid might not be measurable with
sufficient accuracy then disclosure in the notes to the financial statements of a contingent
liability would seem to be appropriate.
10.26 This is an interesting situation. Because of many years of operation, the site would probably
have become quite contaminated and the clean-up costs would be significant. However,
under existing laws within South Australia, a clean-up could only be enforced if the company
ceased operations. A temporary cessation of operations would not be enough for the state to
force a clean-up. Hence, there was not a legal obligation. At issue, therefore, was whether
there was a constructive obligation. If there was a constructive obligation then a liability in
the form of a provision would be recognised (or as a contingent liability if the future cash
flows cannot be estimated with reasonable accuracy). It would be hoped that an entity would
commit to efforts to clean up its land, but if Mobil has made no such commitment then it
could be argued that no constructive obligation exists and no liability would be recognised.
However, there would be little dispute that a clean-up would be required when Mobil finally
leaves the site. Further, it could be argued that given the geographical position of the refinery
in an area of rapidly rising real estate valuesthen the cessation of operations would be
inevitable at some stage in the future. Hence it is difficult to accept that a contingent liability
note should not be provided. This question should be used to elicit alternative views from the
students. What do they think Mobil should do?
10.27 What seems to be the central issue here is whether PIS breached its responsibility to the
investors and therefore whether it is legally obliged to compensate them for their losses. If
there is some uncertainty about this then, at a minimum, PIS should disclose the claims as a
contingent liability (in the notes to the financial statement) with, if possible, a range of
possible outcomes in terms of related cash flows. At the time the article was written it would
probably not be appropriate for the organisation to raise a provision which would appear in
the balance sheet given the apparent uncertainties involved. In discussing the differences
between provisions and contingent liabilities, paragraph 13 of AASB 137 states:
This Standard distinguishes between:
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(a) provisions which are recognised as liabilities (assuming that a reliable estimate
can be made) because they are present obligations and it is probable that an
outflow of resources embodying economic benefits will be required to settle the
obligations; and
(b) contingent liabilities which are not recognised as liabilities because they are
either:
(i) possible obligations, as it has yet to be confirmed whether the entity has a present
obligation that could lead to an outflow of resources embodying economic
benefits; or
(ii) present obligations that do not meet the recognition criteria in this Standard
(because either it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation, or a sufficiently reliable estimate of
the amount of the obligation cannot be made).
To the extent that the payment of compensation to investors is not deemed probable, then
balance sheet recognitions is not appropriate. As paragraph 23 of AASB 137 states:
For a liability to qualify for recognition there must be not only a present obligation but
also the probability of an outflow of resources embodying economic benefits to settle
that obligation. For the purpose of this Standard, an outflow of resources or other
event is regarded as probable if the event is more likely than not to occur, that is, the
probability that the event will occur is greater than the probability that it will not.
Where it is not probable that a present obligation exists, an entity discloses a contingent
liability, unless the possibility of an outflow of resources embodying economic benefits
is remote (see paragraph 86).
Accepting that a contingent liability requires disclosure, paragraph 86 of AASB 137 states:
Unless the possibility of any outflow in settlement is remote, an entity shall disclose for
each class of contingent liability at the reporting date a brief description of the nature of
the contingent liability and, where practicable:
(a) an estimate of its financial effect, measured under paragraphs 36-52;
(b) an indication of the uncertainties relating to the amount or timing of any outflow;
and
(c) the possibility of any reimbursement.

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