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. Therefore, a firm commitment to buy an asset is not a liability. Similarly, an entity does not rec-ognise a liability that might arise in future. The obligation must be present at the balance sheet date.
Constructive obligation
Obligations are usually legal obligations. They arise either from a contract or from the operation of law. Exam-ples of contractual obliga-tions are amount payable to the supplier of goods and services, loan received from the customer, advance received from the customer, debentures and borrowings from financial institutions or public by issuing debentures. Examples of obligations arising from the operation of law are the penalty imposed by SEBI and income tax liability.
A constructive obligation is an obligation that derives from an entity’s actions where: 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 as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. For example, an entity, which has an established practice to replace goods sold with a manufacturing defect even if the defect is brought to notice after the expiry of the product warranty period, should recognise a liability for obligations that might arise from this established practice. Similarly, a liability should be recognised for an obligation arising from wide publicity of the decision of the board of directors to clean the environment polluted by use of the products that the entity manufactures, even if there is no such requirement under the environmental law.
Constructive obligations ultimately get converted into contractual obligations. For example, the constructive obligation for environment cleaning will get converted into a contractual obligation when the contractor will complete the assignment of cleaning the environment. Constructive obligation is an application of the principle of prudence. A liability is recognised immediately when the entity identifies a present obligation, for which it has no option but to settle it.
Creditors, accruals and provisions
A liability is classifies as creditor when the entity has accepted the claim. For example, claims preferred by suppliers of goods and services and accepted by the entity are included in trade creditors. Accruals refer to liabilities for which either claims have not been received or the claims have been received but not accepted by the entity. For example, no claim has been received for services already consumed by the entity. The management fairly accurately estimates those liabilities because it receives similar services almost regularly.
Provisions are liabilities for which the timing and the amount is significantly uncertain. Examples of provisions are provision for product warranty claims, provision for asset retirement obligation, provision for post-retirement employee benefits and provision for taxation. Earnings management
Accruals and provisions provide enough scope for earnings management. An entity may under-estimate the accruals and provisions to boost earnings.Provisions are measured at the best estimate of management. IFRS does not clearly define what is meant by the ‘best estimate of management’. There is a proposal to amend IAS 37, which stipulates the methods for measuring provisions, to bring uniformity of practice and to provide additional guidance. However, the proposed method will not reduce the subjectivity in the measurement of provisions.
Financial liability
In simple terms, financial liability arises from a contract to pay cash or a contract to settle the liability by issue of a financial asset, which will ultimately be converted into cash. Examples of financial liabilities are borrowings from bank or any other institution, trade creditors and security deposits from contractors. Advance from customers is not a financial liability because it is not a contract to pay cash. Financial liabilities are initially measured at fair value less transaction costs. Fair value is lower than the nominal amount if the entity has borrowed at a concessional rate or it is enjoying credit from suppliers for a period longer than six months.The difference is recognised as income. Financial liabilities are subsequently measured at amortised cost using the effective interest rate method.
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