SUMMARY

CHAPTER 5: FINANCIAL LIABILITIES

Definition and Nature of Liabilities

According to IASB, liability is a present obligation of an enterprise arising from past event, the
settlement of which is expected to result in an outflow from the enterprise of resources embodying
economic benefits.

From the definitions given, a liability 0ossess the following essential characteristics:

1. present obligation;
2. past event; and
3. transfer of an economic resource

An obligation is a duty or responsibility to act or perform in a certain way which may be legally
enforceable as a consequence of a binding contract or statutory requirement.

A legal obligation is one that derives from a contract (through its explicit or implicit terms), legislation, or
other operation of law.

A constructive obligation is one that derives from an enterprise's actions whereby an established
pattern of past practice, published policies or a sufficiently specific current statement, the enterprise has
indicated to other parties that it will accept certain responsibilities, and as a result, the enterprise has
created a valid expectation on the part of those other parties that it will discharge those responsibilities.

The settlement of a present obligation involves the enterprise giving up economic resources. Such
settlement of a present obligation may occur in a number of ways, such as by

a. payment of cash;
b. transfer of other assets;
c. provision of services;
d. replacement of an obligation with another obligation; and
e. conversion of the obligation to equity

An obligation always involves another party to whom the obligation is owned. However, it is not
necessary to know the identity of the party to whom the obligation is owed for it to quality as a liability.

Financial Liabilities

As defined in International Accounting Standards 32 Financial Instruments: Presentation, a financial

liability is any liability that is a contractual obligation.

a. to deliver cash or another financial asset to another entity, or

b. to exchange financial assets or financial liabilities to another entity under conditions that are
potentially unfavorable to the entity, or
c. that will or may be settles in the entity's own equity instruments and is a non-derivative for
which the entity may be obliged to deliver a variable number of the entity's own equity
instrument, or
 d. that will or may be settled in the entity's own equity instruments and is a derivative that will or
may be settled other than by exchange of a fixed amount of cash or a financial asset for a fixed
number of the entity's own equity instruments.

Based on the above definition, a financial liability arises from a contract to pay cash, or exchange
financial asset or financial liability. Examples of this nature are accounts payable, notes payable and
bonds and mortgage payable. Financial liabilities also include those contractual obligation that will or
may be settled by issuing equity instrument (e.g. convertible bonds).

Initial Recognition

An entity shall recognize its financial liability when and only when it becomes a party to the contractual
provisions of the instrument; that is, when the entity issues the financial instrument or acknowledge in
whatever form its obligation as s result of the contractual provisions of a contract.

A financial liability is initially recognized at fair value, which is the transaction price. For financial
liabilities that are measured at amortized cost, the transactions costs directly attributable to the
issuance of the financial instrument is considered in the initial measurement.

Measurement Subsequent to Initial Recognition

Except for financial liabilities that are measured at fair value, financial liabilities are subsequent
measured at amortized cost.

Accounting for Specific Financial Liabilities

Accounts payable, or trade accounts payable are liabilities arising from the purchase of goods, materials,
supplies, or services on an open charge-account basis. The credit time period generally varies (e.g. from
30 to 120 days) without any interest being charged on the deferred payment.

Methods of Accounting for Cash

The agreement for the purchase of goods usually includes incentives for early payment of accounts;
thus, cash discounts are offered. The purchase transaction may be recorded using either the gross
methods or the net method.

Under the gross method and when the entity adopts the periodic inventory system, the Purchases
accounts and the Accounts Payable are recorded at the gross invoice price. A cash discount taken on
purchases is recorded upon payment as a credit to Purchases Discounts. Any balance of Purchase
Discounts is reported in profit or loss as a deduction from gross purchases.

Under the net method and when the entity adopts the periodic inventory system, both Purchases and
Accounts Payable are initially recorded at invoice price less the cash discounts available. A cash discount
not taken is recorded as a Purchase Discounts Lost, which is reported in profit or loss as part of finance
cost.

Notes Payable

A promissory note is a written promise to pay a certain sum of money to the bearer at a designated
future time. The promissory notes may arise out of either a trade situation (purchase of goods or
services on credit) or the borrowing of money from a bank, or other transactions.

Note Bearing a Realistic Interest Rate

Accounting for the issuance of interest-bearing note is relatively straightforward. Since the note is
interest bearing (and assuming that the stated rate approximates the prevailing market rate for similar
obligations), the fair value (and also the present value) of the note at the time of its issuance is equal to
its face value.

Note Bearing an Unrealistic Interest Rate

A note bears an unrealistic interest rate when any one or both of these two situations exist:

a. the interest rate appearing on the face of the note is significantly different from the market rate
similar notes; and
b. the consideration received on account of the note issued has a fair value that is significantly
different from the face value of the note.

In such cases, the note and the interest to be paid based on the stated rate are discounted at the market
rate of interest on the date of the issuance.

If the rate stated on the face of the note is higher than the market rate of interest, the discounted
amount is higher than the face value of the note, resulting in premium on notes payable. If the rate
stated on the face of the note is lower than the market rate of interest, the discounted amount is lower
than the face value of the note, resulting in discount on notes payable.

Non-Interest Bearing Note

Accounting for a non-interest-bearing note is slightly more complex and applies the same principle for
notes carrying an interest rate lower than the market rate of interest. A non-interest-bearing note does
not explicitly state an interest rate on the face of the note. It does not mean, however, that there is no
interest imputed on the original obligation. A non-interest bearing note is simply written in a form
where the interest is imputed on the face value of the note. Thus, the face value represents the present
value of the obligation plus the imputed interest for the term of the note.
 Bonds Payable

Nature of Bonds

A bond is a certificate of indebtedness whereby the borrower agrees to pay a sum of money at a
specified future date plus periodic interest payments at the stated rate. They are commonly issued in
denominations of P1,000, P5,000, or P10,000, referred to as face value or par value. Normally, a
corporation sells all of its bonds to an investment firm, referred to as an underwriter, which resells the
bonds to the investing public. In some instances, bonds are sold directly to investors.

The contact between the issuing corporation and the bondholder is known as bond indenture. The bond
indenture specifies the terms of the bonds, rights and duties of both parties, restrictions on the issuing
corporation and all other important details affecting the contracting parties.

Types of Bonds

The more common types of bonds are term bonds, serial bonds, secured bonds, unsecured bonds,
registered bonds, bearer bonds, convertible bonds and callable or redeemable bonds.

Term Bonds and Serial Bonds

Bonds that mature on a single date are called term bonds while bonds that mature in installments are
called serial bonds.

Secured Bonds and Unsecured Bonds

Secured bonds provide security and protection to investors in the form of specific assets of the issuer,
such as real estate or other collateral. A real estate mortgage bond is secured by a lien against real
estate; a collateral trust bond is secured by shares of stocks and bonds held by the issuer as investment;
a chattel mortgage bond is secured by a lien against movable property like motor vehicles.

On the other hand, unsecured bonds, frequently termed as debentures are not protected by the pledge
of any specific asset of the issuing corporation.

Registered Bonds and Bearer (or Coupon) Bonds

Registered bonds are bonds whose owners' names are registered in the books of the issuing corporation.
When these bonds are sold, the transfer agent cancels the original certificate surrendered by the seller,
and a new certificate is issued and registered in the name of the new bondholder. Interest checks are
mailed periodically to the bondholders of record.
Bearer bonds or coupon bonds are not recorded in the name of the owner. Each bond is accompanied by
coupons representing periodic interest payments, covering the life of the issue. The issue of bearer
bonds eliminates the need for recording changes in the ownership as well as preparing and mailing
periodic interest checks.

Callable Bonds and Convertible Bonds

Callable or redeemable bonds are those that give the issuing company the right to call or retire the
bonds before maturity date, usually specified on the bond indenture. The issuing company pays the
bondholder an amount in accordance with the call provisions.

Convertible bonds are those that give the bondholders the right to exchange their bond holdings into a
specified or predetermined number of the issuing corporation's of stock.

Zero-Interest Bonds

Zero-interest bonds, also known as deep-discount bonds, are issued at significantly lower than their face
value. Total interest on these bonds during their entire term is paid together with the principal amount
on maturity date.

Issuance of Bonds

An entity shall recognize financial liability in its statement of financial position when, and only when, the
entity becomes a party to the contractual provisions of the instrument. Thus, bonds payable are initially
recognized at the date of the actual issue of the bonds.

Bond liabilities are initially recognized at their discounted value, which equals the net proceeds from
their issuance. The issue price of the bonds is the market price of the bond, which varies with the safety
of the investment and the prevailing market rate of interest for similar instruments.

Accrued Interest on Bonds Issued

Bonds are often issued at any date between the interest payment dates. Since the issuing corporation
will pay the full periodic interest on all bonds outstanding at an interest date, the bondholder is usually
required to purchase the interest that has accrued interest is added to the issue price of bonds to
determinate the total cash proceeds from the bond issuance.

Transaction Costs on Issue of Bonds

Bond issue costs are expenditures incurred by the issuing company for legal fees, printing and engraving
of bond certificates, taxes, commissions and similar charges. When a financial liability is recognized
initially, an entity shall measure it at its fair value (issue price) and considering transactions costs that
are directly attributable to the issue of the financial liability. This means that bond issue costs form part
of the initial carrying amount of the bond liability. In effect, the net proceeds are reduced by incurrence
of bond issue cost. The determination of the initial amount of the premium or discount on bonds
payable is based on the difference between the face value and the net proceeds.

Premium and Discount Amortization

Bonds are financial liabilities that are subsequently measured at amortized cost. The amortized cost of a
financial liability is the amount at which it is measured at initial recognition minus the principal
repayments plus or minus the cumulative amortization using the effective interest method.

When bonds are issued at a premium or discount, the periodic interest payments made by the issuer to
the investors over bond life do not represent the complete interest expense for the periods involved. In
order to reflect the total interest cost of the bonds, bond premium or discount should be allocated over
the life of the bonds using the effective interest method. This allocation, called amortization, is a
deduction from or addition to the interest expense. The amortization of premium or discount results in
a gradual adjustment of the bond's carrying amount toward the bond's face value and adjustment of the
nominal interest to the effective interest.

Effective Interest Method

Under the effective interest method, a constant interest rate based on the beginning of period carrying
amount of the bonds is recognized as interest expense each period, resulting in unequal recorded
amounts of interest expense. The effective interest methods provides an increasing premium or
discount amortization each period.

To obtain a period's interest expense under this method, the bond's carrying amount at the beginning of
each interest period is multiplied by the effective interest rate. The difference between this amount and
the amount of interest paid or accrued (nominal interest rate x face value of the bonds) is the amount of
discount or premium amortization.