classification of liabilities

International Financial Reporting Standards

The views expressed in this presentation are those of the

presenter, not necessarily those of the IASB or IFRS Foundation.

© IFRS Foundation | 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org

Classification of liabilities

Joint World Bank and IFRS Foundation

‘train the trainers’ workshop hosted by the

ECCB, 30 April to 4 May 2012



presenter,

not necessarily those of the IASB or IFRS Foundation

Concepts—classification of liabilities


© 2010 IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org

3Classification concepts

• Objective of financial reporting

• Financial statements portray financial effects of transactions and events by:

– grouping into broad classes (the elements, egliability)

– sub-classify elements

• IAS 1– application of IFRSs with additional disclosures

when necessary results in a fair presentation (faithful representation of transactions, events and conditions)

– don’t offset assets and liabilities or income and expenses



4

Classification concepts—assets and claims

• Information about the nature and amounts of a

reporting entity’s economic resources and

claims can help users to identify the reporting

entity’s financial strengths and weaknesses.

• That information can help users to:

– assess the reporting entity’s liquidity and

solvency

– its needs for additional financing and how

successful it is likely to be in obtaining that

financing.

(CF.OB13)© IFRS Foundation | 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org


5Classification concepts—claims

• Information about priorities and payment

requirements of existing claims helps users to

predict how future cash flows will be distributed

among those with a claim against the reporting

entity (CF.OB13)


A liability is defined as a:

• present obligation

• arising from a past event

• the settlement of which is expected to lead to

an outflow of future economic benefits from the

entity

6Concept—liability definition


Concept—liability recognition

A liability is recognised when:

• it is probable that any future economic benefit

associated with the item will flow from the

entity; and

• the item has a value that can be measured with

reliability.

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For some items that satisfy the definition of a liability,

significant judgement is required to evaluate whether

such items satisfy the recognition criteria. Individual

IFRSs provide principles and application guidance.




presenter,


Differentiating equity from liabilities


Liabilities and equity

• Differentiation between a financial liability and equity depends on whether there is an obligation to deliver cash (or some other financial asset).

• However, note the exception for certain puttableinstruments.

• When a transaction will be settled in the issuer’s own shares, classification depends on whether the number of shares to be issued is fixed or variable.

9

IAS 32Financial Instruments: Presentation


IAS 32

Financial Instruments: Presentation

• The following are equity:

– Puttable instrument that entitles holder to pro

rata share of net assets on liquidation

– Instrument that is automatically redeemed if

an uncertain future event occurs or death or

retirement of holder

– Subordinated instrument payable only on

liquidation


IAS 32

Financial Instruments: Presentation

• The following are liabilities:

– Instrument is payable on liquidation, but the

amount is subject to a maximum ceiling

– Entity is obliged to make payments before

liquidation – such as mandatory dividend

– Mandatorily redeemable preference shares


Compound financial instruments

• A compound financial instrument, such as a

convertible note, is split into equity and liability

components.

• When the instrument is issued, the equity

component is measured as the difference

between the fair value of the compound

instrument and the fair value of the liability

component.

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Example—compound financial

instrument

• Issuance of convertible debt - Example

– 1/1/X1 issue at par a 4% convertible bond, par and

maturity amount = 50,000, maturity in 5 years

– If no conversion feature, would have paid 6%

– Calculate present value of cash flows at 6%:

– PV 50,000 due in 5 years @ 6% = 37,363

– PV annuity 2,000/year 5 years @ 6% = 8,425

– Total PV = 45,788

Debit cash 50,000

Credit financial liability 45,788

Credit equity (conversion right) 4,212


Treatment of interest, dividends, gains and

losses

• Classification of a financial instrument as a

financial liability or equity determines the

treatment of the interest, dividends, losses or

gains on the financial instrument as items of

income or expense, or as changes in equity.

• ‘dividends’ on shares classified as liabilities are

recognised as expenses and affect profit or

loss.

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Comparison to the IFRS for SMEs

• Section 22 Liabilities and Equity of the IFRS for

SMEs and IAS 32 share similar principles.

15



Judgements and estimates

• Some financial instruments may have the legal

form of equity but their substance is one of a

liability.

• Separating the liability and equity components

requires fair value estimates of the liability

component based on the contractual stream of

future cash flows discounted at the market rate

that would have been applied without the

conversion option.

16



IFRS 2Share-based Payment

Recognition

• The transaction is recognised when the entity

obtains the goods or services.

• Goods or services received are recognised as

assets or expenses as appropriate.

• The transaction is recognised as equity (if equity-

settled) or as a liability (if cash-settled).

• If a payment is required, the payment amount is

based on the price of the entity’s shares (eg

share appreciation rights).

17




presenter,


Classifying liabilities


1919Liability

Liabilities

Contingent

Financial

Provisions

etc

Leases

Defined

Benefit

Deferred

Tax

Classification, recognition and

measurement


Provisions

• A provision is a liability of uncertain timing or

amount (ie recognition is uncertain).

• A liability may be a legal obligation or a

constructive obligation.

• A constructive obligation arises from the entity’s

actions, through which it has indicated to others

that it will accept certain responsibilities, and as

a result has created an expectation that it will

discharge those responsibilities.

20

IAS 37: Provisions, Contingent Liabilitiesand Contingent Assets


21

IAS 37: Provisions, Contingent Liabilities

and Contingent Assets

Examples—provisions

• Ex 1: Waste from A’s factory contaminated the

groundwater. Lawsuit: local community seek

compensation for damages to health from

contamination. A acknowledges wrongdoing.

Court is deciding extent of the compensation.

Lawyers expect ruling in +2 yrs &

compensation in the range of CU1,000,000 to

CU30,000,000.


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• Ex 2: Waste from A’s factory contaminated the groundwater. Required by law to restore the environment. Estimates restoration cost between 1,000,000 & 15,000,000. Unsure of period to complete restoration.

• Ex 3: A manufacturer gives warranties to the purchasers of its goods. Warranty = make good, by repair or replacement, manufacturing defects that become apparent within 3 years of sale.


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Examples—not provisions

• Ex 1: ‘provision’ for self-insurance

• Ex 2: Ski-resort operator operates in a very cyclical business, with ‘good years’ and ‘bad years’ depending primarily on the weather. To reduce earnings volatility, it recognises ‘provisions’ in ‘good years’ to reverse in ‘bad years’.

• Ex 3: ‘provision’ for depreciation

• Ex 4: ‘provision’ for doubtful debts


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Example—constructive obligation

• Waste from A’s factory contaminated the

groundwater. A is not required by law to

restore the contaminated environment & there

is no court case. However, in the reporting

period the entity publicly announced that it

would restore the contaminated environment

within the next 12 months.


Contingent liabilities

• Contingent liabilities are:

• possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity.

• obligations that are not recognised because their amount cannot be measured reliably or settlement is not probable (eg litigation against the entity when the occurrence of any wrongdoing by the entity is uncertain and it is more likely than not that the entity will successfully defend the case).

• Contingent liabilities are not recognised—definition and recognition criteria are not met.

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26



Example—contingent liability

• A community is seeking compensation from A for damages to their health as a result of contamination believed to be caused by A’s plant.

It is doubtful whether A is the source of the contamination because

– many entities operate in the same area producing similar waste & it is unclear which entity is the source of the leak

– A has taken precautions to avoid leaks and is vigorously defending the case.


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Example—contingent liability continued

• However, it is not certain that it did not caused the leak and the true offender will only become known after extensive testing has been performed.

A’s legal counsel expects a court ruling in approximately 2 years. If A loses the case, compensation is likely to be in the range of CU1,000,000 to CU30,000,000.


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Example—contingent liability continued

It may be uncertain whether the entity has a

present obligation—this is the matter being

determined by the court.

– if taking account of all of the available

evidence, it is probable that the entity will

successfully defend the court case then the

entity has a possible obligation and hence a

contingent liability.



• In some cases judgement is used to determine

whether to recognise a provision (liability) or

merely to disclose a contingent liability.

• For example, when defending a court case in

which it is difficult to predict the outcome.

• In other cases judgement is used to determine

whether to disclose a contingent asset.

• For example, a plaintiff in a court case in

which it is difficult to predict the outcome.

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2011 October | Sao Paulo IFRS Conference

All financial liabilitiesAmortised

cost

FVO for

mismatch,

managed on

FV basis and

hybridsExcept:

Held for trading

Fair value

through

P&L

Own

credit in

OCI

• Hybrid financial liabilities are bifurcated

• No reclassification permitted

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Classification model: financial liabilities

IFRS 9 Financial Instruments



• Classification of financial assets into IFRS 9 categories drives the subsequent measurement and requires careful consideration of all available evidence.

• Classification is made primarily based on an entity’s business model

• Fair value measurement requires maximum possible use of observable market data and the minimum use of entity-specific factors.

• In the absence of a quoted active market, it will be necessary to use valuation techniques.

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IFRS 9 Financial Instruments


Classification of leases

• A finance lease transfers to the lessee substantially all the risks and rewards incidental to ownership of the leased asset.

• All other leases are operating leases.

• When a lease includes both land and buildings elements, the classification of the land and building elements are considered separately.

– in determining whether the land element is an

operating or finance lease, an important

consideration is that land normally has an indefinite

economic life.

32

IAS 17Leases


33

IAS 17

Leases

• Situations that individually or in combination normally indicate a finance lease:– lease transfers ownership of the asset to

lessee– from inception lessee reasonably certain to

exercise bargain purchase option– lease term is for the major part of asset’s

economic life– at inception PV of MLPs = substantially all

asset’s fair value– specialised asset (only lessee can use

without major modifications)


34

IAS 17

Leases• Situations that individually or in

combination could indicate a finance lease– lessee can cancel the lease but

compensates the lessor’s for associated losses

– gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee

– lessee can continue the lease for a secondary period at a rent that is substantially lower than market rent


Examples—lease classification

• Ex 1: On 1/1/20X1 enter into 5-yr non-cancellable lease over a machine.

Machine’s cash cost = 100,000, economic life = 10 yrs and residual value = 0.

Annual lease payments on 31/12: 4 ×23,000 & 23,539 at end of yr 5 when ownership transfers to the lessee.

The interest rate implicit in the lease is 5% p.a. which approximates lessee’s incremental borrowing rate.

35



• Ex 2: Same as Ex 1 except ownership of the machine does not automatically transfer to the lessee at the end of the lease. Instead, the lessee has an option to acquire the machine from the lessor on 1/1/20X6 for CU1.

• Ex 3: Same as Ex 1 except economic life of the machine is five years and ownership of the machine does not transfer to the lessee at the end of the lease.

36



• Ex 4: Same as Ex 1 except ownership does

not transfers to lessee at the end of the lease.

Instead lessee has an option to continue the

lease asset for a further 5 years at a rent of

CU1 per year.

• Ex 5: Same as Ex 1 except ownership

transfers to the lessee at the end of the lease

for a variable payment equal to the asset’s

then fair value (instead of 23,539).

37


Operating leases

• The leased asset remains in the statement of

financial position of the lessor.

• Operating lease payments are usually

recognised in profit or loss on a straight-line

basis.

• From the perspective of the lessee, if payments

are subject to escalation, straight-line

recognition is profit or loss may give rise to a

liability on the statement of financial position

38

IAS 17Leases


Finance leases

• Finance leases are accounted for by lessees as

an asset purchased (other IFRSs then apply to

the asset) on credit (a liability).

• Initially, the liability is recognised at:

• the fair value of the leased property, or if lower

• The present value of the minimum lease

payments—the implicit interest rate is used as

the discount rate

39

IAS 17Leases


Employee benefits

• Employee benefits are all forms of consideration

paid for services of employees or for termination

of employment.

• IAS 19 separates employee benefits into 4

categories:

• short-term benefits

• post-employment benefits

• other long-term benefits

• termination benefits

40

IAS 19Employee Benefits


Short-term employee benefits

• Short-term employee benefits are expected to

be settled wholly before 12 months after the

period in which the employee rendered the

related service.

• recognise as an expense as the employee

provides the related service

• measure obligations at undiscounted amounts

(application of the cost constraint)

• no disclosures specified in IAS 19.

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42

IAS 19

Employee Benefits

• Examples of Short-term employee benefits include:– wages, salaries & social security

contributions;– S/T compensated absences (paid annual

leave & paid sick leave) for absences expected to occur within 12 month limitation;

– profit-sharing & bonuses payable within 12 month limitation; &

– non-monetary benefits (such as medical care, housing, cars and free or subsidised goods or services) for current employees.


Post-employment benefits

• Post-employment benefits are payable after the completion of employment.

• Two types:

• defined contribution plan, entity pays fixed contributions to a separate entity (a fund) and has no legal or constructive obligation to pay further contributions if the fund cannot pay the employee.

• all other post-employment plans are defined benefit plans.

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Post-employment benefits—defined

contribution

• Employees (not the employer) are exposed to risks.

• Employer:

• recognises contributions payable as an expense as

the employee provides services in exchange for the

contributions.

• measures obligations for unpaid contributions at

undiscounted amounts (application of the cost

constraint).

• disclose amount recognised as an expense.

44



Post-employment benefits—defined benefit

• Recognise the defined benefit liability as follows:

• use the projected unit credit method based on actuarial assumptions to measured the obligation at its present value; less

• the fair value of plan assets (if any).

• Recognise all changes in the defined benefit liability (asset) when they occur:

• service costs and net interest in profit and loss

• remeasurements in other comprehensive income.

• Extensive disclosures specified.

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Other long-term benefits

• Other long-term benefits are all employee

benefits other than short-term employee

benefits, post-employment benefits and

termination benefits (eg long-service leave)

• Recognition and measurement is the same as

that for post-employment benefits: defined

benefit plans.

• No disclosures specified in IAS 19.

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Termination benefits

• Termination benefits arise only on termination, rather than during employment.

• Principle—the event that gives rise to an obligation is the termination of employment rather than employee service

• Recognise expense and a liability at the earlier of:

• when the entity can no longer withdraw the offer of those benefits

• when the entity recognises the related restructuring provision in accordance with IAS 37.

• No disclosures specified in IAS 19.

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48

Questions or comments?

Expressions of individual

views

by members of the IASB and

its staff are encouraged. The

views expressed in this

presentation

are those of the presenter.

Official positions of the IASB

on accounting matters are

determined only after

extensive due process and

deliberation.


© IFRS Foundation | 30 Cannon Street | London EC4M 6XH | UK | www.ifrs.org

49

The requirements are set out in International Financial Reporting Standards (IFRSs), as issued by the IASB at 1 January 2012 with an effective date after 1 January 2012 but not the IFRSs they will replace.

The IFRS Foundation, the authors, the presenters and the publishers do not accept responsibility for loss caused to any person who acts or refrains from acting in reliance on the material in this PowerPoint presentation, whether such loss is caused by negligence or otherwise.

49

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