Liability definition

Liability definition

The current liability definition is that a liability of an entity 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.

For years the IASB is working on a revision of this definition in the project Review of the Conceptual Framework, because of perceived problems with existing definitions and recognition criteria for assets and liabilities.

Asset definition

The current asset definition is that an asset of an entity is a resource controlled by the entity, as a result of past events, from which future economic benefits are expected to flow to the entity.

These two definitions proved useful tool for many years but for some problems (refer to the two definitions above):

  • Confusion on which is the asset or liability?
    • the resource vs inflows of economic benefits that the resource may generate
    • the obligation vs outflows of economic benefits that the obligation may generate
  • What is the role of uncertainty?
    • Definitions: ‘Expected’
    • Recognition criteria: ‘Probable’

Suggested revised Conceptual Framework definitions

The liability definition is that a liability of an entity is a present obligation of the entity to transfer an economic resource as a result of past events.

The asset definition is that an asset of an entity is a present economic resource controlled by the entity as a result of past events.

An economic resource = a right, or other source of value, that is capable of producing economic benefits

Guidance on terms

Liability

A liability is a present obligation to transfer an economic resource.

The obligation must be an obligation of the entity. In other words, the entity must be the party that is bound by the obligation. This feature of the definition corresponds to the fact that the proposed definition of an asset specifies that the entity must be the party that controls the asset. The identity of the party bound by an obligation will often be evident from the contracts, statutes or other evidence that establish that the obligation exists.

If a liability exists for one party, an asset always exists for another party or parties, except perhaps for some obligations to clean up damage to the environment. However, for some assets, such as rights over physical objects, no corresponding liability exists.

To transfer an economic resource

An obligation to transfer an economic resource may result in an entity paying cash, transferring assets other than cash, granting a right to use an asset, rendering services or standing ready to make a payment on the occurrence of a future event that is outside the entity’s control.

In some cases, an entity may have an obligation that it will settle by exchanging it for a secondLiability definition obligation, for example, by issuing a financial liability. If that second obligation requires the entity to transfer an economic resource, then the first obligation is also an obligation to transfer an economic resource.

The following do not give rise to a present obligation to transfer an economic resource:

  1. a requirement to provide economic resources only if, at the same time or earlier, the entity expects to receive economic resources of equal or greater value (see also the discussion on executory contracts); and
  2. an obligation that an entity is permitted (or required) to fulfil by issuing its own equity instruments as ‘currency’. Although those equity instruments are a resource for the holder, they are not an economic resource for the issuer. Consequently, an obligation to issue equity instruments is not an obligation to transfer an economic resource. As explained in Examples that are not economic resources, below this is the case even if the issuer previously held those equity instruments as ‘treasury shares’.

‘Present’ obligation

The IASB proposes to define a liability as a ‘present’ obligation to transfer an economic resource as a result of past events. A present obligation is one that exists at the reporting date. The economic resource to be transferred need not exist at that date, nor need the entity control it already at that date. In many cases, an entity has a present obligation that it will fulfil with economic resources that it will acquire in the future.

To identify a liability it is necessary to distinguish between present obligations and possible future obligations.

A present obligation must have arisen ‘as a result of past events’. An entity typically incurs anLiability definition obligation to transfer an economic resource in exchange for receiving a different economic resource or as a result of conducting an activity for which another party seeks payment from the entity. For example:

  1. an entity incurs an obligation to transfer goods and services to a customer in exchange for consideration received from that customer.
  2. an entity may incur an obligation to pay a tax or a levy as a result of earning revenue or profits. The amount of the obligation would be determined by reference to the revenues or profits earned.
  3. an entity may incur an obligation to compensate an injured party as a result of having committed an act of wrongdoing.

A liability can be viewed as having arisen from past events if the amount of the liability will be determined by reference to benefits received, or activities conducted, by the entity before the end of the reporting period. Activities conducted by the entity could include, for example, making sales, earning profits or even operating on a particular date—the important fact is that the amount of the liability is determined by reference to that activity.

However, difficulties are encountered in practice because it is unclear whether those past events are sufficient to create a present obligation to transfer an economic resource if such a transfer remains conditional on future events that have not occurred, or on further actions that the entity has not taken, by the reporting date.

There can be two types of future events on which an obligation remains conditional:

  1. those whose occurrence is outside the control of the entity (see Future events outside the control of the entity below); and
  2. those whose occurrence depends on the entity’s future actions (see Future events that depend on the entity’s future actions, below).

Future events outside the control of the entity

With some obligations, the requirement to transfer an economic resource will depend on the occurrence of future events that are outside the control of the entity. Such obligations include, for example:

  1. an insurer’s obligation to compensate a policyholder on the occurrence of an insured event, such as damage to property;
  2. a guarantor’s obligation to compensate a lender if a borrower defaults;
  3. an entity’s obligation to redeem a financial instrument for cash if the holder of the instrument exercises an option to require redemption; or
  4. an entity’s obligation to make an additional payment for purchased plant or equipment if the plant or equipment proves to be capable of operating to standards specified in the purchase contract.

Obligations of this kind are sometimes called ‘stand-ready obligations’. Although the entity does not know at the reporting date whether it will be required to transfer resources, it has an unconditional obligation to stand ready to transfer the resources if the specified future event occurs. The IASB has concluded that these unconditional obligations are present obligations that meet the definition of a liability.

Future events that depend on the entity’s future actions

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Three alternative views are discussed:

View 1: a present obligation must have arisen from past events and be strictly unconditional

One view is that a present obligation must have arisen from past events and be strictlyLiability definition unconditional. The amount of a future transfer might be determined by reference to the entity’s past activities.

But, for as long as the entity could, at least in theory, avoid the transfer of resources through its future actions, it does not have a present obligation. In other words, if an entity must take a series of actions before it has an unconditional obligation, no liability exists until it has taken all of the actions.

View 2: a present obligation must have arisen from past events and be practically unconditional

The view described in View 1 above requires a present obligation to be strictly unconditional. It identifies a present obligation by reference to the last in the series of actions that an entity must take before it is unconditionally required to transfer a resource to another party. However, the last action might be a relatively minor one—an incidental condition that may have some commercial substance but that the entity does not have the practical ability to avoid in its particular circumstances.

It could be argued that, in such circumstances, treating the last event or action as the one that creates a present obligation does not faithfully represent the entity’s financial position. A more faithful representation would identify as liabilities all obligations to transfer an economic resource:

  1. that have arisen as a result of past events, ie that will be measured by reference to benefits received, or activities conducted, by the entity before the end of the reporting period (see this link); and
  2. that the entity has no practical ability to avoid through its future actions.

The assessment of whether an entity has the practical ability to avoid any remaining conditions would require judgement. Guidance might be needed (possibly in individual Standards) to identify the types of condition that an entity might not have the practical ability to avoid. Arguably, these conditions might include, for example, conditions that the entity could avoid only by ceasing to operate as a going concern, significantly curtailing operations or leaving specific markets.

Further guidance might be needed to address situations in which the amount of the future transfer will depend on the extent to which the entity carries out an activity, for example, if future lease payments are a proportion of the entity’s future revenue. A lessee might have the practical ability to avoid some, but not all, of the future activity.

View 3: a present obligation must have arisen from past events but may be conditional on the entity’s future actions

The first two views discussed in this section are that, for a present obligation to exist, it is not sufficient that the entity has received an economic resource or conducted an activity on which the amount of possible future transfer will be determined. It is also necessary that the obligation is either strictly unconditional (View 1) or practically unconditional (View 2).

An alternative view is that the past event is sufficient to create a present obligation: it is not necessary for the obligation to be (strictly or practically) unconditional. An obligation arises when the entity receives a resource or conducts an activity, in exchange for which another party will be able to demand a transfer of resources if the entity meets further conditions.

As soon as the entity has received the resource or conducted the activity, it no longer has complete discretion to avoid a future transfer. The future transfer may be conditional on the entity’s future actions but the obligation has arisen from past events (the past receipt or activity) and so is a present obligation.

The entity has a liability if, on meeting the further conditions specified, it will be required:

  1. to transfer an economic resource that it would not have been required to transfer without the past receipt or activity; or
  2. to exchange economic resources with another party on more onerous terms than would have been required without the past receipt or activity.

Economic resource

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Economic resource Economic resource Economic resource Economic resource Economic resource

Economic resources may take various forms:

  1. enforceable rights established by contract, law or similar means, such as:
    1. enforceable rights arising from a financial instrument, such as an investment in a debt security or an equity investment.
    2. enforceable rights over physical objects, such as property, plant and equipment or inventories. Such rights might include ownership of a physical object, the right to use a physical object or the right to the residual value of a leased object.
    3. enforceable rights to receive another economic resource if the holder of the right chooses to exercise that right (an option to acquire the underlying economic resource) or is required to exercise that right (a forward contract to buy the underlying economic resource). Examples include options to receive other assets, net rights under forward contracts to buy or sell other assets and rights to receive services for which the entity has already paid.
    4. enforceable rights to benefit from the stand-ready obligations of another party.
    5. enforceable intellectual property rights (for example, registered patents).
  2. rights arising from a constructive obligation of another party.
  3. other sources of value if they are capable of generating economic benefits. Examples of such economic resources include:
    1. know-how;
    2. customer lists;
    3. customer and supplier relationships;
    4. an existing work force; and
    5. goodwill. The IASB concluded in paragraphs BC313–BC323 of the Basis for Conclusions on IFRS 3 Business Combinations that goodwill does meet the definition of an asset. However, recognising internally generated goodwill does not provide relevant information.
  4. some assets, particularly many services, that are consumed immediately on receipt.

Economic benefits derived from an asset are the potential cash flows that can be obtained directly or indirectly in many ways, for example, by:

  1. using the asset to produce goods or provide services;
  2. using the asset to enhance the value of other assets;
  3. using the asset to fulfil liabilities;
  4. using the asset to reduce expenses;
  5. leasing the asset to another party;
  6. selling or exchanging the asset;
  7. receiving services from the asset;
  8. pledging the asset to secure a loan; and
  9. holding the asset.

For a physical object, such as an item of property, plant and equipment, the economic resource is not the underlying object but a right (or set of rights) to obtain the economic benefits generated by the physical object.

Accordingly, although there is a difference in degree between full, unencumbered legal ownership of, for example, a machine and a right to use such a machine for a fixed period under a lease, there is no difference in principle. Both full ownership and the lease give rise to assets, and both provide rights to use the underlying machine, albeit for a period that may be less than the useful life in the case of the leased asset:

  1. in the case of the right to use under a lease, the lessee’s right is to obtain some of the benefits generated by the machine—those benefits generated during the period for which the lessee has the right of use; and
  2. in the case of full, unencumbered legal ownership, the owner’s right is to obtain all of the benefits generated by the machine throughout its useful life.

In many cases, economic resources will comprise various different rights. For example, if an entity has legal ownership of a physical object, the economic resource will comprise rights such as:

  1. the right to use the object;
  2. the right to sell the object;
  3. the right to pledge the object; and
  4. legal title to the object (ie any rights conferred by legal title that are not mentioned separately in (a)–(c)).

In many cases, one party holds all these rights. Sometimes, as in a lease, different parties each hold some of the rights.

In many cases, an entity treats all of the rights it holds as a single asset. Nevertheless, an entity would treat some of the rights as one or more separate assets if such a separation produces information that is relevant to users of financial statements and provides a faithful representation of the entity’s resources, at a cost that does not exceed the benefits of doing so.

An entity should describe an economic resource in a manner that is clear, concise and understandable. For example, if an entity has legal ownership of a machine and all rights associated with that machine, strictly speaking the entity’s asset is the bundle of all rights associated with that machine. However, it would generally be perfectly clear, concise and understandable to describe the entity’s asset as a machine, rather than as rights to a machine.

More detailed and sophisticated descriptions of the asset would be needed only in less common circumstances in which a summarised or non-technical description would not convey the nature of the asset. Furthermore, it would typically be acceptable, and indeed preferable, to use a concise label on the face of the statement of financial position, providing any necessary details in the notes.

Sometimes, a single resource contains obligations as well as rights. For example, contracts create a series of rights and obligations for each party. The unit of account will determine whether the entity accounts for that package as a single asset or a single liability or as one or more separate assets and one or more separate liabilities.

Generally, when a package of rights and obligations arises from the same source, an entity will account for them at the highest level of aggregation that enables it to depict the rights and obligations, and the changes in those rights and obligations, in the most relevant, faithful and understandable manner.

The unit of account will determine whether a contract is viewed as giving rise to a single net right or net obligation, or to one or more separate rights and obligations. Offsetting is not the same as having a single (net) right or a single (net) obligation. When a single (net) right or a single (net) obligation exists in a particular case, the entity has only a single asset or a single liability.

For example, suppose that an entity holds an option to buy an asset if it pays CU100 and that the asset has an expected value of CU140.19 The entity does not have an asset of CU140 and a liability to pay the strike price of CU100. Instead, the entity has an asset of CU40. In contrast, offsetting arises when an entity has both an asset and a liability and recognises and measures them separately, but presents them as a single (net) amount (possibly with disclosure of the separate asset and liability).

Established enforceable rights above under (a) refers to enforceable rights. A right is enforceable if the holder of the right can ensure that it is the party that will receive, and can retain, any economic benefits generated by the right. Enforce-ability does not mean that the entity can ensure that those economic benefits will arise. For example, shares normally give the holder an enforceable right to receive its share of any dividends that the issuer chooses to pay, even if the holder cannot compel the issuer to declare a dividend.

The following are examples of items that do not meet the definition of an economic resource and hence do not meet the definition of an asset:

  1. debt or equity instruments issued by the entity and repurchased and held by it (for example, treasury shares). Similarly, in consolidated financial statements, debt or equity instruments issued by one member of the consolidated group and held by another member of that group are not economic resources of the group. Those instruments are not capable of providing economic benefits to the reporting entity because the reporting entity cannot have a claim on itself. (However, if another party held those equity instruments, they would be an asset for that party because they are capable of providing economic benefits, such as dividends.)
  2. a call option on the entity’s own equity instruments. This is not an asset for the issuer of the equity instruments because the underlying equity instruments that would be received on exercise are not an asset for the entity. (However, if another party held that call option, the call option would be an asset for that party, because the equity instruments would be an asset for that party.)

Control of an economic resource

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An entity controls an economic resource if it has the present ability to direct the use of the economic resource so as to obtain the economic benefits that flow from it.

For an entity to control an economic resource, the economic benefits arising from the resource must flow to the entity (either directly or indirectly) rather than to another party. This requirement does not imply that the entity can ensure that the resource will generate economic benefits in all circumstances. Instead it means that, if the resource generates economic benefits, the entity is the party that will receive them.

An entity has the ability to direct the use of an economic resource if it has the right to deploy that economic resource in its activities or to allow another party to deploy the economic resource in that other party’s activities. Many economic resources take the form of legally enforceable rights, such as legal ownership or contractually enforceable rights that establish the entity’s ability to direct the use of the economic resource.

However, sometimes an entity establishes its ability to direct the use of an economic resource by having access that is not available to others, for example, by having possession of the economic resource and being able to prevent access to it by others. This can be particularly relevant for assets such as know-how and customer lists.

An entity does not control an economic resource if it does not have the present ability to direct the use of the economic resource. Consequently, the following are not assets of an entity:

  1. rights of access to public goods, such as open roads, if similar rights are available to any party at no cost.
  2. fish in water to which access is not restricted. Although a potential source of economic benefits, this is not an economic resource of any one entity because those benefits are available to any party. (An exclusive right to catch fish would be an asset of an entity that has that right. Similarly, if fishing quotas are introduced, the quota of each party would become an asset of that party, though the rights associated with possession of the fish would still not become an economic resource until the fish are caught.)
  3. knowledge that is in the public domain and freely available to anyone without significant effort or cost. No party controls such knowledge.

When determining whether an entity controls an economic resource, it is important to identify the economic resource correctly. For example, Entities A, B and C may jointly own real estate on terms that provide them with 25 per cent, 40 per cent and 35 per cent respectively of the economic benefits flowing from that real estate.

In the absence of any other agreements that modify control, each party controls its proportionate interest in the underlying economic resource (in this example, the real estate). No single party controls the underlying real estate in its entirety.

Also think of – Control: principal and agent

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Something else -   Executory contract
Something else -   Conceptual Framework for Financial Reporting

 

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