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Chapter 11

AFM391 Chapter Notes - Chapter 11: Contingent Liability, Current Liability, Financial Statement


Department
Accounting & Financial Management
Course Code
AFM391
Professor
Christine Wiedman
Chapter
11

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Chp 11: Current Liabilities & Contingencies
1
What is a liability?
Liability: 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
3 key elements:
1. A present obligation of an entity
2. Arising from past transactions (or events)
3. The settlement of a liability account is expected to result in an outflow of economic benefits (e.g.,
cash, other financial assets, delivery of goods or provision of services)
This is an “and” situation → All 3 criteria MUST be satisfied.
Enforceability of Obligations
Present obligations are normally legally enforceable, but can also be constructive in nature:
Constructive obligations: arise from the firm’s recurring practices (i.e. when past or
present company practice shows that the entity acknowledges a potential economic
burden)
E.g. Legal vacation pay is 4%, but company has historically paid 6%
A company that regularly repairs its products even after warranty period (to maintain good
customer relations), would report a liability for the amounts expected to be expended in the
warranty period and in period after
Recognition of Liabilities
A business may know that it has a present obligation and that it is probable it will have to settle
this obligation in the future, but it may be uncertain of the timing or amount of the liabilities
For a liability to be recognized on the financial statements:
A precise $ amount of obligation is NOT required
Only, a reliable $ estimate is required
Cases where a reliable estimate cannot be made are extremely rare
Liabilities with estimated amounts are:
1. Provisions (e.g., warranties, employee pension obligations, and corporate restructuring costs)
2. Contingent liabilities (e.g., lawsuits)
Financial and Non-financial liabilities
There are two types of liabilities:
1. Financial
2. Non-financial
Why distinguish between financial and non-financial liabilities?
IFRS requires that some financial liabilities be measured at fair value rather than
amortized cost

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2
Thus, whether an obligation is a financial or non-financial liability may impact how the
debt is valued → hence the distinction is important
Financial liabilities
Financial liability is any liability that is a contractual obligation to deliver cash or other financial
assets (e.g. equity instruments) to another party
Contractual obligation:
enforceable and legally binding
specifies all significant terms, including fixed or minimum payments and the method of
settlement (e.g. cash, equity); and
specifies the approximate timing of the transaction.
E.g. a loan from a bank is a financial liability of the company that borrowed the money
Non-financial liabilities
Non-financial liabilities are obligations that meet the liability criteria but are not financial
liabilities
Instead of cash or other financial assets, they are typically settled through the delivery
of goods or provisions of services such as:
Publisher’s obligation to the subscribers to deliver the magazine
Warranties
Unearned revenues (e.g. airline flight)
Finance lease obligation
Bank loan
Bonds payable
Obligation under customer loyalty plan
Liabilities established by legislation (such as income taxes payable and provincial sales tax
payable) are non-financial liabilities as they are NOT contractual in nature
So, even thought they are settled in cash, they are non-financial liabilities because they
are NOT contractual in nature
P11-1
1. A/P - F bc contract
2. Warranty payable - NF bc G&S
3. USD Bank Loan - F
4. Bank overdraft - F
5. Sales tax payable - NF bc legislation
6. Unearned revenue - NF
Current Liabilities

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3
Current liabilities are obligations that are expected to be settled within one year of the balance
sheet or the business’s normal operating cycle, whichever is longer
As most businesses’ operating cycle are one year or less, current liabilities are simply referred to
obligations due in one year
In addition to the length of time until maturity, certain financial liabilities classified as fair value
through profit or loss (FVPL) are reported as current liabilities.
In practice, few companies elect to report financial liabilities as FVPL
Current liabilities are presented separately from non-current liabilities on the balance sheet
Alternatively, liabilities may be presented in order of liquidity when it results in more reliable
and relevant information (e.g., financial institutions)
Measurements of Liabilities
Measurement of a liability is typically based on the nature of the obligation:
Financial liabilities
Financial liabilities at FVPL (e.g. those held for trading such as derivatives) should be:
Initially and subsequently measured at fair value
Other financial liabilities (e.g. not FVPL such as bonds) should be:
Initially measured at fair value less the transactions costs directly associated with
incurring the obligation
Subsequently (e.g. after acquisition date) measured at amortized cost using the
effective interest method (same initial interest rate)
Non-financial liabilities
The measurement of non-financial liabilities depends on their nature. For example:
Warranties are recorded at management’s best estimate of the future cost of meeting
the entity's obligations
Liability for prepaid magazine subscription cost are valued at the consideration initially
received less the amount earned to date through performance
Current liabilities, contingencies, and financial guarantees
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