Faculty of commerce and public management Advanced accounting 2 Assignment Group 2 In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.A liability is defined by the following characteristics: * Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time; * A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand; * A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement; and, * A transaction or event obligating the entity that has already occurred.Liabilities in financial accounting need not be legally enforceable; but can be based on equitable obligations or constructive obligations. An equitable obligation is a duty based on ethical or moral considerations. A constructive obligation is an obligation that is implied by a set of circumstances in a particular situation, as opposed to a contractually based obligation. The accounting equation relates assets, liabilities, and owner's equity: The accounting equation is the mathematical structure of the balance sheet.
Liabilities are reported on a balance sheet and are usually divided into two categories: * Current liabilities — these liabilities are reasonably expected to be liquidated within a year.They usually include payables such as wages, accounts, taxes, and accounts payables, unearned revenue when adjusting entries, portions of long-term bonds to be paid this year, short-term obligations * Long-term liabilities — these liabilities are reasonably expected not to be liquidated within a year. They usually include issued long-term bonds, notes payables, long-term leases, pension obligations, and long-term product warranties. ------------------------------------------------- ------------------------------------------------- The Valuation of Liabilities * Liabilities may be defined as currently existing obligations which the firm intends to meet at some time in the future.Such obligations arise from legal or managerial considerations and impose restrictions on the use of assets by the firm for its own purposes.
To be recognized as a liability in accounting, the following tests must be satisfied: (a) the liability must exist at the present time; (b) it must involve expenditure in the future; (c) it must be ascertained with reasonable accuracy; (d) it must be quantifiable; (e) its maturity date must be known at least approximately The capital invested by the owner or shareholders in an enterprise is not regarded as a liability in accounting. Shareholders have a right at law to the payment of a dividend once it has been declared.As a result, unpaid or unclaimed dividends are shown as current liabilities. It is the practice to show proposed dividends as current liabilities also, since such proposed dividends are usually final dividends for the year which must be approved at the annual general meeting before which the accounts for the year must be laid. The valuation problem The valuation of liabilities is part of the process of measuring both capital and income, and is important to such problems as capital maintenance and the ascertainment of a firm's financial position. Hence, 'the requirements for an accurate measure of the financial position and financial structure should determine the basis for liability valuation.
Their valuation should be consistent with the valuation of assets and expenses’ The need for consistency arises from the objectives of liability valuation, which are similar to those of asset valuation. Probably the most important of these objectives is the desire to record expenses and financial losses in the process of measuring income. However, the valuation of liabilities should also assist investors and creditors in understanding the financial position of the firm. In accordance with the manner of valuing assets in economics, liabilities may be valued at their discounted net values; in accordance with accounting conventions, they may be recorded at their historic value, that is, the valuation attached to the contractual basis by which they were created.There is no gap between the two methods of valuation as regards liabilities which are payable immediately and it is only as the maturity date of liabilities lengthens that the gap appears. Whilst accounting conventions dictate that the valuation of liabilities should be based on the sum which is payable, it is accounting practice to make a distinction between current and long-term liabilities.
As regards current liabilities, there is little difference between the discounted net value and the contractual value of liabilities. In this connection, current liabilities are defined as those which will mature during the course of the accounting period. The gap between the two methods of valuation is significant as regards long-term liabilities.Long-term liabilities are valued on the basis of their historical value, that is, by reference to the contract from which they originated, and hence, during periods of inflation or where the interest payable is less than the current market rate of interest, the accounting valuation will certainly be overstated by comparison with the discounted net value. Here again, a true perspective on this problem may be obtained by reference to the separate role of the accountant and the investor which we stated in the introduction to this part.
The accountant records the liability as the sum which will be payable: it is for the investor to value the real cost of that future burden. Valuation Methods There three principal valuation approaches, the Market Approach, the Income Approach and the Cost Approach.Within each approach, there are various methods that have evolved and that are used to a greater or lesser extent for different types of asset/liability or in different markets. all three approaches are applicable to the valuation of liabilities.
Market Approach The Market Approach provides an indication of value by comparing the subject liability with identical or similar liabilities which are actively traded and for which price information is available. If financial instruments, insurance and pension liabilities are excluded there are few liabilities for which an active market exists and for which price information is available. Income ApproachThe Discounted Cash Flow method is a very common method under the Income Approach and has many detailed variations. The Discounted Cash Flow Method indicates that the discount rate should reflect the time value of money and the relative risks associated with the cash flow. Those risks are comprised of market (or systematic) risks and asset or entity specific risks.
The discount rate also has to reflect the nature of the cash flows to which it is being applied. Some apply these principles to the value of liabilities. However, many argue that when valuing a liability the systematic and market risks that are associated with a corresponding asset are of little or no relevance.Whereas an increased risk to an investor in an asset is rewarded by an increase in the required return and a corresponding reduction in the capital value, an increase in the risk associated with a liability should increase the negative value of the liability, not decrease it. Also, the risk faced by a holder of a liability is that the cost of fulfilling the liability when it becomes due exceeds the sum set aside to meet it and is correlated with the nature of the liability rather than the nature of the asset.
For example, the risk associated with accepting a sum today to reflect future cost of remediating a contaminated industrial site is correlated with the risks associated with the contamination and the procedures necessary for its remediation, not with the risks associated with investment in uncontaminated industrial land.For this reason it is argued that the risks associated with a liability are often better reflected in the cash flows than in the discount rate. Cost Approach The Cost Approach can be applied in the valuation of assets when there is either no relevant transactional data that can be applied to use a Market Approach or no sufficiently reliable income projections to use an Income Approach. The cost of fulfilling a liability may be a direct indication of its value or an input into another approach or method that may be used for measuring a liability, whether it is to be actually fulfilled or transferred, settled or cancelled. The Board is interested in any methods or techniques used under the Cost Approach for valuing liabilities within the scope of this project. .
References
