Deegan5e Sm Ch10

PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY Chapter 10 An overview of accounting for liabilities 10.1

10.2

Pursuant to the Framework for the Preparation and Presentation of Financial Statements, for an item to be characterised as a liability the following attributes should exist: 

there must be a probable future sacrifice;



the obligations must be specific to the reporting entity;



the transaction giving rise to the obligation must already have occurred; and



the amount of the obligation and time of its settlement must be measurable with reasonable accuracy.

Pages 362 to 366 of your text address contingent liabilities. A useful decision tree is provided on page 364. Paragraph 10 of AASB 137 defines a contingent liability as: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability. A contingent liability is therefore considered to exist where there is a possibility that the reporting entity will be obliged (not currently obliged) to transfer resources in the future as a result of a future happening, for example, an agreement (such as a guarantee) that has already been entered into, or the outcome of a future event (such as a legal judgement in a negligence claim), and the amount is potentially material. As there might be no current obligation (the obligation is contingent upon a future event), the item would not qualify for inclusion in the balance sheet. If the probability that a future cash flow will occur is deemed to be remote then no disclosure is required. A contingent liability is also deemed to exist when there is an existing obligation, but that obligation cannot be measured with reasonable accuracy. If something cannot be measured with reasonable accuracy then it will not be included in the balance sheet. A contingent liability should be disclosed in the notes to the financial statements. Failure to be aware of potential and material liabilities that the firm may be subject to can make the accounts misleading.

10.3

AASB 137 defines a provision as a liability of uncertain timing or amount. Paragraph 11 states that provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. According to paragraph 14 of AASB 137, a provision shall be recognised when:

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(a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognised. If there is a legal requirement that $15 million must be paid to clean up the contamination, and if the amount is deemed to be a reliable estimate of the clean-up costs, then a provision should be recognised. However, even if there is not a legal obligation then it is possible that there is a constructive obligation to undertake the clean-up, and a provision would also be recognised. A constructive obligation is defined in AASB 137 as: an obligation that derives from an entity’s actions where: (a) 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 (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

10.4

(a)

Provision for repairs A provision for repairs has traditionally been disclosed as a liability, possibly classified into current and non-current portions. However, from the perspective of the AASB Framework, repairs would not qualify as liabilities as they do not involve a present obligation to an external party. AASB 137 also acts to exclude many provisions from being classified as liabilities, and indeed, from being shown anywhere within the financial statements given that many ‘provisions’ do not create obligations to make future sacrifices of economic benefits to parties external to the entity.

(b)

Provision for long-service leave Under generally accepted accounting principles, a provision for long service leave would be shown as a liability, broken up into current and non-current portions. As a future obligation exists to an employee (that is, to an external party) which could be measurable with some accuracy (perhaps using various actuarial assumptions), and it relates to work performed by the employee in the past, the liability would also be recognised pursuant to the AASB Framework and other accounting requirements.

(c)

Dividends payable Dividends payable is an interesting issue. Previously, under generally accepted accounting principles, a provision for dividends would have been shown as a current liability at the time they were proposed, rather than subsequently when they were approved (typically at an annual general meeting held after the balance sheet date). This was the case even though the reporting entity did not ratify the dividend until the annual general meeting which is typically held a number of weeks after balance date

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(an after balance date event). This seemed to be a reasonable thing to do if it was probable that the dividend would be paid at a future date (that is, ratification appeared a formality), and the dividend did relate to earnings made prior to year end. However, pursuant to AASB 110 ‘Events After the Balance Sheet Date’, a liability for dividends payable can only be recognised once the ultimate payment has been approved by the appropriate parties. (d)

A guarantee for the debts of a subsidiary Under generally accepted accounting principles this would be classified as a contingent liability, and if it is potentially material, then it should be disclosed in the notes to the financial statements. If the guarantee has become enforceable then the liability would be included in the balance sheet as either a current or non-current liability. The guarantee would not be classified as a liability for inclusion in the balance sheet (unless it had become enforceable) as the entity would not be obliged to transfer resources as at reporting date.

10.5

The issue price of a debenture will equal the face value when the coupon rate on the debenture is the same as the rate required by the market. If the market requires a higher rate of return than the coupon rate, then the debentures will be issued at a discount. The issue price will be reduced sufficiently below par (or face value) so as to cause the effective rate of return on the income stream, and repayment of the principal, to be equal to the market’s required rate of return. When the coupon rate is greater than the required market rate, then the issue price will increase to the point at which the effective rate of return equals the rate of return required by the market.

10.6

All things being equal, it is generally considered that the higher the level of debt, the higher the perceived risk of an entity. When an entity issues debt capital it is required to pay interest periodically as well as the principal at the end of the debt term. Interest payments reduce reported profits. If something is deemed to be equity then the related payment is a dividend— and dividends are an appropriation of profits and therefore do not reduce profits. The greater the levels of debt, the greater the cash flow obligations which must be met regardless of whether the entity is generating profits and/or positive cash flows from its operations. This can be contrasted with equity capital. For ordinary shares there is no fixed obligation to pay dividends. Organisations often enter contractual arrangements which restrict the amount of debt they can issue, such as debt to asset constraints. When debt levels are high this may be considered as an indication that the organisation is close to breaching its debt covenants. This could be viewed in a negative light by the capital market.

10.7

When a new accounting requirement is introduced, for example as a result of a new Accounting Standard being issued, this may have adverse effects on contractual clauses that have already been negotiated within debt contracts. At the extreme, the release of new Accounting Standards may cause a borrowing organisation to be in technical default of particular contractual clauses (for example, a new Accounting Standard may require that all items of a specific type which had previously been considered to be assets must be written off. This in turn may lead to problems relating to particular debt to asset constraints). To

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reduce the problems associated with unanticipated changes to Accounting Standards, an entity may seek to renegotiate its contracts with the respective lenders. If the debt issue was made to the public then obtaining the approval for a change to the contract from a majority of the lenders may be very difficult to achieve. In the case of a private issue of debt only one party may be involved, and negotiating with this one party may be much easier. 10.8

This is an argument that is raised on page 371 of the textbook. The counter-argument is that there are social costs associated with removing the incumbent management team which warrant consideration in their own right, but that these social costs are typically ignored by traditional financial accounting practices.

10.9

It is determined by the difference between the present value of the future cash flows associated with the debenture (interest and principal receipts), and the face value of the debenture. The present value of the future cash flows is determined by discounting the interest annuity, and the principal repayment, at the market’s required rate of return.

10.10 Redeemable preference shares If the preference share provides for mandatory redemption or gives the holder of the ‘share’ the right to require the issuer to redeem the instrument on or after a particular date for a fixed or determinable amount, then the instrument is a financial liability. That is, if the holder of the preference share has a ‘right’ to require the issuing company to redeem the preference share then, regardless of the probability of the redemption, the share would be disclosed as a liability. This represents a departure from the AASB Framework. However, if the option for redemption is at the option of the issuer the instrument would not be considered to represent a liability unless the issuer has notified holders that it intends to redeem to instruments. Perpetual convertible notes Convertible notes can often be considered to be part debt and part equity. AASB 132 ‘Financial Instruments: Disclosure and Presentation’ notes that to the extent that the holder of the note has an option to require the company to pay cash to them, then there is a liability element. There is also an equity element to the extent that the notes can be converted to shares. Hence, for perpetual convertible notes there will be both a liability and an equity component. The financial liability component is the contractual obligation to deliver cash and the equity instrument is a call option granting the holder the right, for a specified period of time or at a specific date or dates, to convert into equity instruments of the issuer. The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument and options to purchase equity instruments, or issuing a debt instrument with detachable equity instrument purchase options. Accordingly, in such cases, the issuer presents liability and equity elements separately on its balance sheet. We will not consider how to determine the amounts of the equity and liability components in this answer (this issue is covered in Chapter 15). Preference shares Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

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If the preference shares are not redeemable at the option of the holder and do not provide for cumulative dividends then they would qualify as equity. On the other hand, if the terms of a non-redeemable preference share create a contractual obligation of the issuer to pay cumulative dividends of a fixed amount on determinable dates, that share constitutes a financial liability, the fair value of which represents the present value of the stream of the contractually required future dividends. Each preference share issue would need to be considered individually. Paragraph AG 26 of AASB 132 states: When preference shares are non-redeemable, the appropriate classification is determined by the other rights that attach to them. Classification is based on an assessment of the substance of the contractual arrangements and the definitions of a financial liability and an equity instrument. When distributions to holders of the preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, the shares are equity instruments. The classification of a preference share as an equity instrument or a financial liability is not affected by, for example: (a) a history of making distributions; (b) an intention to make distributions in the future; (c) a possible negative impact on the price of ordinary shares of the issuer if distributions are not made (because of restrictions on paying dividends on the ordinary shares if dividends are not paid on the preference shares); (d) the amount of the issuer’s reserves; (e) an issuer’s expectation of a profit or loss for a period; or (f) an ability or inability of the issuer to influence the amount of its profit or loss for the period. Subordinated loans A subordinated loan is defined as one that is given a lower ranking for repayment than some or all other debts of the entity. Nevertheless, it ranks above share capital in terms of repayment on liquidation. Given their preferential repayment terms relative to equity, they should be treated as debt. 10.11 A provision for warranty repairs would be recorded and disclosed. It is a liability as there would be a present legal obligation to parties external to the organisation. It would be disclosed as a provision because the amount and timing of the future sacrifice of economic benefits that will be made is uncertain. The amount of the provision would be based on the probability that people would return the boats for repairs, and on the actual costs associated with the repairs. To the extent that discounting to present values will not be materially different to the undiscounted value, Brighton Ltd might elect to disclose the liability without discounting. 10.12 Expectations relating to future refits and refurbishments are not of the nature of liabilities because there is no present obligation to an external party. No provision would be recognised at reporting date because no obligation for refurbishment exists independently of the entity’s future actions. The intention to undertake the refit/refurbishment depends upon the entity deciding to continue using the assets. Rather than recognising a provision, the depreciation Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

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recognised each period should take account of the consumption of the economic benefits inherent in the asset. When the refurbishment/refit occurs such expenditure would be capitalised consistent with AASB 116 ‘Property, Plant and Equipment’ and then depreciated over subsequent periods. 10.13 There is a legal obligation enforceable by an external party, and hence a liability in the form of a provision should be recognised (we would classify it as a provision because the amount and the timing of the payments are uncertain). Assuming that the restoration work would not be undertaken for a number of years, then the provision would be disclosed as a non-current liability. The liability, and the associated expense, should be recognised over the life of the mine and throughout the operations of the entity and as the work necessitating the restoration is undertaken. The liability would be discounted back to its present value. 10.14 This really depends upon the intentions and/or business practices of Elwood Ltd. Although there might be no legal obligation, this does not mean that Elwood will not recognise a liability, as a constructive obligation might be deemed to exist. A constructive obligation is defined at paragraph 10 of AASB 137 as: an obligation that derives from an entity’s actions where: (a) 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 (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. Hence, if the entity has a history of disregarding its responsibilities to the environment and there is no legal requirement to decontaminate the land, then no liability might be recognised. However, the organisation might have publicly released policy statements that state that the organisation takes its environmental responsibilities very seriously—if so, a constructive liability might be deemed to exist and disclosure would be appropriate. 10.15 The debt covenant (such as a debt to asset constraint, or an interest coverage clause) may be based on rolling generally accepted accounting principles, that is, the principles in place at the time the ratios are calculated. If this is the case, when a new accounting standard is issued then this will potentially change how certain accounting numbers used with a covenant are calculated. Many accounting-based contracts will be subject to rolling GAAP given that it is not possible to pre-specify all accounting methods in advance. When a new Accounting Standard is issued which prohibits certain methods which had previously been used, this is considered to represent a change to GAAP. If a contract relies, at least in part, on rolling GAAP then the release of a new or amended Accounting Standard may cause changes to the reported assets, liabilities, expenses or revenues of a reporting entity. To the extent that the affected accounting numbers are used within particular accounting-based contracts, the new Standards could potentially lead to a violation of an existing debt covenant. 10.16 Paragraph 32 of AASB 132 states: The issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability

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(including any embedded non-equity derivative features) that does not have an associated equity component. The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole. Hence, we would determine the present value of $20 to be paid in one month and allocate this to the liability component. The rate of interest to be used would be the market’s required rate of return on a similar debt instrument that does not have the attached equity component. The balance of the $20 (which would be small) would represent the equity component. If the equity component is so small as not to be deemed to be material then the whole instrument could be disclosed as debt. 10.17 In this question, the interest payments of 10% are made each 6 months for 5 years. Therefore, we will treat the debentures as offering a coupon rate of 5% over 10 periods. Similarly, the market rate will be calculated as 4% for 10 periods. (a)

The issue price is equal to the present value of the interest annuity and the principal repayment. The discount rate is the market’s required rate of return, in this case, 4%. Issue price:

PV of principal = 1 000 000 x 0.6755642 = PV of annuity = 50 000 x 8.1108957 =

675 564 405 545 1 081 109

Because the market rate is less than the coupon rate of the debentures, the debentures are issued at a premium as shown above. (b)

(i)

1 July 2008 Dr Cr Cr

Cash Debenture liability Debenture premium

1 081 109 1 000 000 81 109

To amortise the premium using the effective-interest method, we may use the following table. Within the table, the interest expense is determined by multiplying the opening liability by the required market rate of interest, in this case, 4% per annum.

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Period 1 2 3 4 5 6 7 8 9 10 (ii)

Interest expense 43 244 42 974 42 693 42 401 42 097 41 781 41 452 41 110 40 754 40 385

Cash payment 50 000 50 000 50 000 50 000 50 000 50 000 50 000 50 000 50 000 50 000

Premium 6 756 7 026 7 307 7 599 7 903 8 219 8 548 8 890 9 246 9 615

Closing liability 1 074 353 1 067 327 1 060 020 1 052 421 1 044 518 1 036 299 1 027 751 1 018 861 1 009 615 1 000 000

30 June 2009 (which is the second 6 month period) Dr Dr Cr

(iii)

Opening liability 1 081 109 1 074 353 1 067 327 1 060 020 1 052 421 1 044 518 1 036 299 1 027 751 1 018 861 1 009 615

Interest expense Debenture premium Cash

42 974 7 026 50 000

30 June 2010 (which is the fourth 6 month period) Dr Dr Cr

Interest expense Debenture premium Cash

42 401 7 599 50 000

10.18 In this question, the interest payments of 8% are made each 6 months for 6 years. Therefore, we will treat the debentures as offering a coupon rate of 4% over 12 periods. Similarly, the market rate will be calculated as 3% for 12 periods. (a)

The issue price is equal to the present value of the interest annuity and the principal repayment. The discount rate is the market’s required rate of return: in this case, 4%. Issue price:

PV of principal = $2 000 000 x 0.7014 = PV of annuity = $80 000 x 9.9540 =

$1 402 800 796 320 $2 199 120

Because the market rate is less than the coupon rate of the debentures, the debentures are issued at a premium, as shown above. (b)

(i)

1 July 2008 Dr Cr Cr

Cash Debenture liability Debenture premium

2 199 120

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2 000 000 199 120

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(ii)

30 June 2009 The amortisation of the premium each 6 months would be calculated as $199,120  12 = $16 593 Dr Dr Cr

(iii)

Interest expense Debenture premium Cash

63 407 16 593 80 000

30 June 2010 As the straight-line method is being used, the entry will be the same as 30 June 2009.

10.19 In this question, the interest payments of 10% are made each 6 months for 10 years. Therefore, we will treat the debentures as offering a coupon rate of 5% over 20 periods. Similarly, the market rate will be calculated as 6% for 20 periods. (a)

The issue price is equal to the present value of the interest annuity and the principal repayment. The discount rate is the market’s required rate of return, in this case, 6%. Issue price:

PV of principal = 1 000 000 x 0.31180 = PV of annuity = 50 000 x 11.46992 =

311 800 573 496 885 296

Because the market rate is more than the coupon rate of the debentures, the debentures are issued at a discount as shown above. (b)

(i)

1 July 2008 Dr Dr Cr

Cash Debenture discount Debenture liability

885 296 114 704 1 000 000

To amortise the premium using the straight-line interest method, we simply divide the discount by the number of periods. The interest expense in each period will be the same. Discount amortisation = 114 704 divided by 20 = 5735. (ii)

30 June 2009 Dr Cr Cr

(iii)

Interest expense Debenture discount Cash

55 735 5 735 50 000

30 June 2010 As per 30 June 2009, given that the straight-line method is used.

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10.20 In this question, the interest payments of 8% per annum are made each 6 months for 5 years. Therefore, we will treat the debentures as offering a coupon rate of 4% over 10 periods. Similarly, the market rate will be calculated as 5% for 10 periods. (a)

The issue price is equal to the present value of the interest annuity and the principal repayment. The discount rate is the market’s required rate of return, in this case, 5%. Issue price:

PV of principal = 5 000 000 x 0.6139 = PV of annuity = 200 000 x 7.7217 =

3 069 500 1 544 340 4 613 840

Because the market rate is greater than the coupon rate of the debentures, the debentures are issued at a discount as shown above. (b)

(i)

1 July 2008 Dr Dr Cr

Cash Debenture discount Debenture liability

4 613 840 386 160 5 000 000

To amortise the discount using the effective-interest method, we may use the following table. Within the table, the interest expense is determined by multiplying the opening liability by the required market rate of interest: in this case, 5% per annum. Period 1 2 3 4 5 6 7 8 9 10

Opening liability 4 613 840 4 644 532 4 676 759 4 710 597 4 746 127 4 783 433 4 822 605 4 863 735 4 906 922 4 952 268

Interest Cash expense payment 230 692 200 000 232 227 200 000 233 838 200 000 235 530 200 000 237 306 200 000 239 172 200 000 241 130 200 000 243 187 200 000 245 346 200 000 247 614 200 000

Discount Discount amortis. balance 30 692 355 468 32 227 323 241 33 838 289 403 35 530 253 873 37 306 216 567 39 172 177 395 41 130 136 265 43 187 93 078 45 346 47 732 47 614 118

Closing liability 4 644 532 4 676 759 4 710 597 4 746 127 4 783 433 4 822 605 4 863 735 4 906 922 4 952 268 4 999 882*

* the balance should be 5 000 000. The difference is due to using present value tables which are only to 4 decimal places. (ii)

30 June 2009 (which is the second 6 month period) Dr Cr Cr

Interest expense Debenture discount Cash

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232 227 32 227 200 000

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(iii)

30 June 2010 (which is the forth 6 month period) Dr Cr Cr

Interest expense Debenture discount Cash

235 530 35 530 200 000

10.21 Arguably, given the materiality of the financial amounts involved, and the implications for Coca-Cola’s reputation, the organisation should have disclosed information about the law suit in those financial reports that were released following the first time they were aware of the legal action. Initially, any reference to the law suit would probably be restricted to the notes to the financial statements given the difficulty involved in assessing the likely payments, and also because of the contingent nature of the action. Once it becomes probable that a payment will be made, and that amount can be reliably measured, then the amount should be included within the liabilities of the entity. 10.22 Given the materiality of the amounts involved, the financial reports released by Foster’s should make some reference to the lawsuit. Whether it is disclosed in the notes as a contingent liability, or recognised as a liability for inclusion in the statement of financial position depends on the perceived probability that Foster’s will ultimately lose the lawsuit. There is also the issue as to whether any ultimate payment can be reliably estimated. If they believe that they will not have to pay, disclosure in the notes is still warranted, and arguably, some reference should be made to estimates of the amounts potentially involved. A review of Foster’s 2001 annual report shows that the following information pertaining to the lawsuit was disclosed under a contingent liabilities note. An identical note appeared in the 2000 annual report. The liquidator of the Emanuel Group of companies has commenced legal action against several companies in the Group, including FBG Limited. The claims allege wrong doing in relation to certain financing and related transactions between Emanuel and the Group. The Group has been advised that the claims should fail. FBG Limited and the other controlled entities that are party to the action have denied liability for the claim and are vigorously defending the proceedings. Students are encouraged to discuss whether they consider that the above note is sufficient to inform financial statement users about the potential magnitude of any settlement. 10.23 Clearly the action being taken against Pacific Dunlop is financially significant. The issue is whether this significance, or potential significance, is reflected in the organisation’s financial report. Could the readers of the financial report be given an objective appreciation of the progress of the lawsuits, and the possible implications for the company? This question is useful to stimulate discussion amongst the students about whether they think the note disclosure is adequate. Because much professional judgement is involved in determining the contents of a contingent liability note, there is really no ‘right’ or ‘wrong’ answer to this question. Generally speaking, and in comparison with many other reporting entities, the note disclosure provided by Pacific Dunlop is fairly reasonable. Perhaps more information about the probable upper-limit of the associated costs would have been useful, but perhaps the company’s managers would argue that the outcome is too uncertain to try to quantify the settlement. What is obvious from reading the Contingent Liability note of Pacific Dunlop is that the organisation has numerous contingent liabilities, a great deal of which are potentially very significant. As such amounts are not reflected in the balance sheet, it is imperative that Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

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financial statement users review the notes for an awareness of additional liabilities that could potentially become payable. 10.24 A number of issues would be relevant here before deciding how details about the lawsuit of the Ten subsidiary would be disclosed. Is Eye Corp liable for the payment, or is it a liability of Mr Nettlefold? What is the probability that the claim will succeed? What is likely to be the amount of a settlement, if the claim is successful? Given the many uncertainties involved, it would be unlikely that the company would include any obligations associated with the claim in its balance sheet. However, to be prudent, the notes to the financial statements should provide details of the claims, information about the perceived likelihood that the action will succeed, and, if possible, the estimated amounts and timing of any settlement. Where there is uncertainty, the company could elect to provide a range of possible settlement amounts. 10.25 The whole issue associated with the establishment of a separate entity to ‘take responsibility’ for the obligations of another entity is interesting. The actions of James Hardie and its apparently under-funded compensation fund attracted a great deal of attention throughout 2004 and 2005. By James Hardie’s actions it does appear to have accepted responsibility for the health impacts caused by the production of its products. Given this apparent acceptance, and given the argument that the compensation fund has insufficient funds to meet future obligations, then it would be appropriate for James Hardie to make some form of disclosure in its annual report. Because the additional amounts to be paid might not be measurable with sufficient accuracy then disclosure in the notes to the financial statements of a contingent liability would seem to be appropriate. 10.26 This is an interesting situation. Because of many years of operation, the site would probably have become quite contaminated and the clean-up costs would be significant. However, under existing laws within South Australia, a clean-up could only be enforced if the company ceased operations. A temporary cessation of operations would not be enough for the state to force a clean-up. Hence, there was not a legal obligation. At issue, therefore, was whether there was a constructive obligation. If there was a constructive obligation then a liability in the form of a provision would be recognised (or as a contingent liability if the future cash flows cannot be estimated with reasonable accuracy). It would be hoped that an entity would commit to efforts to clean up its land, but if Mobil has made no such commitment then it could be argued that no constructive obligation exists and no liability would be recognised. However, there would be little dispute that a clean-up would be required when Mobil finally leaves the site. Further, it could be argued that given the geographical position of the refinery —in an area of rapidly rising real estate values—then the cessation of operations would be inevitable at some stage in the future. Hence it is difficult to accept that a contingent liability note should not be provided. This question should be used to elicit alternative views from the students. What do they think Mobil should do? 10.27 What seems to be the central issue here is whether PIS breached its responsibility to the investors and therefore whether it is legally obliged to compensate them for their losses. If there is some uncertainty about this then, at a minimum, PIS should disclose the claims as a contingent liability (in the notes to the financial statement) with, if possible, a range of possible outcomes in terms of related cash flows. At the time the article was written it would probably not be appropriate for the organisation to raise a provision – which would appear in the balance sheet – given the apparent uncertainties involved. In discussing the differences between provisions and contingent liabilities, paragraph 13 of AASB 137 states: This Standard distinguishes between: Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

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(a) provisions – which are recognised as liabilities (assuming that a reliable estimate can be made) because they are present obligations and it is probable that an outflow of resources embodying economic benefits will be required to settle the obligations; and (b) contingent liabilities – which are not recognised as liabilities because they are either: (i) possible obligations, as it has yet to be confirmed whether the entity has a present obligation that could lead to an outflow of resources embodying economic benefits; or (ii) present obligations that do not meet the recognition criteria in this Standard (because either it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation, or a sufficiently reliable estimate of the amount of the obligation cannot be made). To the extent that the payment of compensation to investors is not deemed probable, then balance sheet recognitions is not appropriate. As paragraph 23 of AASB 137 states: For a liability to qualify for recognition there must be not only a present obligation but also the probability of an outflow of resources embodying economic benefits to settle that obligation. For the purpose of this Standard, an outflow of resources or other event is regarded as probable if the event is more likely than not to occur, that is, the probability that the event will occur is greater than the probability that it will not. Where it is not probable that a present obligation exists, an entity discloses a contingent liability, unless the possibility of an outflow of resources embodying economic benefits is remote (see paragraph 86). Accepting that a contingent liability requires disclosure, paragraph 86 of AASB 137 states: Unless the possibility of any outflow in settlement is remote, an entity shall disclose for each class of contingent liability at the reporting date a brief description of the nature of the contingent liability and, where practicable: (a) an estimate of its financial effect, measured under paragraphs 36-52; (b) an indication of the uncertainties relating to the amount or timing of any outflow; and (c) the possibility of any reimbursement.

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