6ee59Liabilities

8/3/2019 6ee59Liabilities

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Liabilities



Definition:

• A liability is the present obligation of an enterprise

arising from past events, the settlement of which is

expected to result in an outflow from the

enterprise embodying economic benefits.• In other words liabilities arise from past

transactions or events that will require the future

payments of assets or performance of services.

• Examples : buying goods on credit, accepting

advance payment from customer, taking a bank

loan.



I am not a liability !

• Example : A company may sign a three year

contract with a supplier for purchase of copper for

Rs.1,00,000 per year. This is commitment to pay

for purchase to be made in the future. Thecompany is not obliged to pay until the

merchandise is purchased . Since there is no

present obligation, no liability is recorded when

the contract for purchase of goods is signed.



Classification Of Liabilities

Current Liabilities

Long-term Liabilities

Secured Loans

Unsecured Loans



Current Liabilities

• Obligations that expected to be paid withinone year of the Balance Sheet date or within

the operating cycle of the business,

whichever is longer. These liabilities areusually paid by using existing current assets

or by creating other current liabilities.

•

Examples: Creditors, Bills Payables, bank overdraft , unearned revenues and accrued

expenses.




• Liabilities that will not be due in the next

year or in the operating cycle are classified

as long-term liabilities.

• Examples: Debentures payable, long-term

loans, lease rental payables and pension

payables.



Secured Loans

• Secured loans are those where the specific

assets of the borrower are pledged,

hypothecated or mortgaged as security. If

the borrower defaults the creditor can sell

the assets and use the proceeds to settle the

dues.



Unsecured Loans

• Are incurred based on the general credit

standing of the borrower since they are

only backed by the legal claim against the

general assets of the borrower.



Current Liabilities

Definite Liabilities

Estimated liabilities



Definite Liability

• Current Obligations that are determined

precisely.



Bills Payable

• When a business buys merchandise orequipment on credit or take loads, it issues

bills payable to the seller or lender.

• Example: Suppose that Singhal Corporationborrowed Rs. 10,000 from Hindustan

Finance by signing a bills payable.

May 1 Cash A/c Dr. 10000

To Bills Payable 10000



• When Singhal Corporation pays the bill on

the maturity date july 30

July 30 Bills Payable A/c Dr 10000

Interest ExpenseA/c

Dr.

300

To Cash 10300

Paid 90 day , 12% bill payable of Rs. 10000 with interest



Sales Tax Payable

• A tax imposed by the government at thepoint of sale on retail goods and services. It is collected by the retailer and passed on to

the state• It is based on a percentage of the selling

prices of the goods and services and set bythe state.



Accounting Treatment

• Madura enterprises sell goods Rs. 1000 plus

10% sales Tax.

Nov 19 Cash A/c Dr 1100

To Sales 1000

To Sales tax

Payable

100

To record sales and collection of sales tax



Nov 19 Sales tax PayableA/c

Dr.

100

To cash 100

To record the payment of sales tax



Value Added Tax

• Meaning : VAT has replaced sales tax on

most goods. The purpose of VAT is to

eliminate the cascading effect of sales tax.

When a dealer buys goods and pays VAT, hecan claim credit for the amount paid from

tax payable by him when he sells the goods .

As a result each buyer pays tax on theincrease in the value of the goods.



Illustration

• Madhur company bought the goods on

september 27 for Rs.800 plus VAT at 10%.

Sept 27 Purchases A/c Dr 800

VAT Credit

Receivable

80

To Cash 880

To record purchase including VAT paid



At the time of sale

Nov 19 Cash A/c Dr 1100

To Sales 1000

To Sales tax

Payable

100

To record sales and collection of sales tax



The entry to record the payment

of TAX

Dec 4 Sales Tax Payable

A/c Dr

100

To VAT 80

To Cash 20

To record payment and of sales tax



Current Portions of Long-term

Debt

• A portion of long-term debt may be payable inthe course of next 12 months. For examplesuppose that a loan of Rs. 100000 is to be paid

in installments of Rs.10000 in the next 10years.

• Consistent with the definition of current liabilities an enterprise must classify the

installment of Rs. 10000 payable in the next year as “long-term debt due within oneyear” under current liabilities.



Interest Accrued But Not Due On

Loans

• Interest is due and payable on loans on the

date specified in the agreement. The amount

of interest accrued upto the end of

accounting period is shown as the current liability.

• In contrast interest accrued and due should

be included under either secured orunsecured loans.



Estimated Liabilities or Provisions

• Are definite obligations for which the

precise amount cannot be determined

presently. The only accounting problem is to

make a reasonable estimate of the amount of the liability and record it.

• Examples: income tax, product warranties

and employee benefits.



Income Tax

• A company is a separate entity and must filetax returns and pay tax on its income.

• The Central Govt. levise central corporate tax in

accordance with the Income Tax Act 1961.• The computation of large corporations is very

complex because it must take intoconsideration not only the provisions of the act

but also decisions of the courts andinstructions issued by central board of direct taxes.



Contd…

• Besides, disputes with the tax authorities overthe amount of tax payable involve time-consuming legal procedures.

•The precise amount of income tax is seldomknown when the financial statements areprepared.

• Since income tax is the expense of the year in

which income is earned the liability should beestimated and recorded by the adjusting entryat the end of the year.



Illustration

• Income tax expense is Rs. 36500. The

following entry records the liability:

May 1 Income Tax Expense

A/c Dr.

10000

To Income Tax

Payable

10000

To record estimated income tax expense



Product Warranties

• A warranty or guarantee is given to the purchaser bya product manufacturer or provider of a service withthe understanding that the manufacturer orprovider will replace or repair a defective product or

make good an ineffective service within apredetermined span of time.

• The cost of the warranty is an expense of the periodin which the product is sold since the warrantyhelped the sale.

• The exact amount of warranty is not known at thetime of sale and the warranty expense is estimatedbased on past experience.



Illustration

• Assume that a company sells watches at anaverage price of Rs.1500 with one yearwarranty. Under warranty for a year thecompany will replace free of cost any defective

part but the labor charges to be paid by thecustomer.

• During the year ended 31st March 2011, thecompany sells 2000 watches.

• Past experience shows that the 5% of thewatches are defective and the cost of thewarranty replacement is Rs.50 per unit.



The adjustment entry to estimated

warranty expense and liability will be :

March 31 Product Warranty

Expense A/c

Dr.

5000

To estimated

warranty liability

5000

To record estimated product warranty and liability



When a watch is serviced under warranty bthe

cost of the repair is charged to the estimated

warranty account.

• Example: Assume that 13 watches are returned in

April because of defects and the company carried

out repairs at a cost of Rs.45 per watch. The

transaction is recorded as follows:

April 30 Estimated warranty

liability A/c

Dr.

485

To Cash 485

To record replacement of parts under warranty



Dividends Payable

• Are distributions of assets by the company.

The BOD proposes a certain rate of

dividends to the shareholders who may

accept or reject the proposal.

• The proposed dividend becomes a liability

when it is accepted by the shareholders.

• There is no need to show a liability when

the proposal is made.



Contingent Liabilities

• Is a possible obligation that arises from past events and the

existence of which will be confirmed only by the

occurrence or (b) a present obligation that arises from past

events but is not recognized because

• (i)it is not probable that an outflow of resources

embodying economic benefits will be required to settle the

obligation; or

• (ii) a reliable estimate of the amount of the obligation

cannot be made.



Contd…

• A contingent liability will be confirmed by theoutcome of an uncertain event.

• Either it may result from a remote possibility or areliable estimate of the liability that cannot be made.

• A contingent liability is “iffy”

• Once the uncertainty surrounding the outcome of the event is resolved the contingent liability willeither become a full fledged liability or altogethereliminated.

• Example: Tax liability disputed, product liabilitysuits and demands for increase in bonus or wages.



Accounting Treatment

• It depends on the expected outcome of the contingency.

• If it is probable that the contingency will occur that isthe probability is greater than .50 and the amount of theresulting loss can be reasonably estimated thecontingent liability should be recorded in the accounts.

• However if the contingency is not possible though it mayoccur or the amount of contingent loss cannot beestimated , the contingency should be disclosed in thenotes of the financial statements.

•

A contingency which may be only remotely possibleneed not be disclosed .




• Debentures, mortgages , leases and

pensions.



Debentures

• Debentures are creditor ship securities representinglong-term indebtedness of a company. A debenture is aninstrument executed by the company under its commonseal acknowledging indebtedness to some person orpersons to secure the sum advanced. It is, thus, a

security issued by a company against the debt.• Debentures, like shares, are equal parts of loan raised by

a company.

• Like shares, they are issued to the public at part, at apremium or at a discount. Debenture-holders arecreditors of the company. They have no voting rights but their claims rank prior to preference shareholders andequity shareholders. Their exact rights depend upon thenature of debentures they hold.

Contd



Contd… • It’s a written promise to pay a principal amount at a specified time

as well as interest on the principal at a specified rate per period.

• A debenture certificate is issued to each lender as evidence of thecompany’s obligation toe the debenture holder.

• The debenture trust deed also known as indenture is the legal

document that states the rights and obligation of the debenture

holders and the issuer.

• This deed contains a number of covenants for the protection of

the lenders. The covenants deals with many matters including

interest rate to be paid , maturity date and amount and further

borrowings by the issuer.

•

A company can sell directly to the public or the underwriter• The issuer appoints a bank or a debenture trustee to represent

large number of debenture holders

• The primary function is to ensure the issuer complies with the

terms of the trust deed.



Secured and Unsecured

Debentures

• Secured or mortgaged debentures- debentureswhich are backed by specific assets to ensureits repayment. Most debentures issued in India

are secured by mortgage . Pledge orhypothecation.

• Unsecured debentures, on the other hand, haveno such charge on the assets of the company.

• The are issued by the general creditworthinessof the issuer.They are also known as simpledebentures.



Registered and Bearer Debentures

• Registered debentures are registered with thecompany. Name, address and particulars of holdings of every debenture holders are recorded on the debenturecertificate and in the books of the company. At the timeof transfer, a regular transfer deed duly stamped and

properly executed is required. Interest is paid only to theregistered debenture holders.

• Bearers debentures on the other hand, are transferredby more delivery without any notice to the company.Company keeps no record for such debentures.

Debentures-coupons are attached with the debentures-certificate and interest can be claimed by the coupon-holder.



Redeemable and Irredeemable

Debentures• Redeemable debentures are those which can be

redeemed or paid back at the end of a specified periodmentioned on the debentures or within a specifiedperiod at the option of the company by giving notice tothe debenture holders or by installments as per terms of

issue.• Irredeemable debentures are those which are

repayable at any time by the company during itsexistence. No date of redemption is specified. thedebenture holders cannot claim their redemption.

However, they are due for redemption if the companyfails to pay interest on such debentures or on winding upof the company. They are also called perpetualdebentures



Convertible and Non-convertible

Debentures

• Convertible debentures are those which can

be converted by the holders of such

debentures into equity shares or preference

shares. A convertible debenture has astipulated conversion rate of some number

of shares for each debenture.



Zero-coupon Bonds

• A debt security that doesn't pay interest (a

coupon) but is traded at a deep discount,

rendering profit at maturity when the

bond is redeemed for its full face value.

Also known as an "accrual bond".



Debenture Ratings

Investment

Quality

CRISIL ICRA CARE

Highest Safety AAA LAAA CARE AAA

High Safety AA LAA CARE AA

Adequate Safety A LA CARE A

Moderate

Safety

BBB LBBB CARE BBB

Inadequate

Safety

BB LBB CARE BB

High Risk B LB CARE B

Substantial Risk C LC CARE C

In Default D LD CARE D



Accounting For debentures

• All debentures have a face value or par value

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