12.1 Definition
From the “Why Accounting?” (Intermediate Accounting 1) Chapter, recall that the definition of liability 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” (CPA Canada, 2016, 4.4 b). This definition embodies three essential concepts.
First, the liability needs to be a present obligation. This means that at the financial reporting date the entity must have some legal or constructive force that will compel it to settle the obligation. This suggests that the company has no effective way to avoid the obligation. Although this often is the result of the ability of the creditor to legally enforce payment, liabilities can still exist even in the absence of a legal authority. The concept of a constructive obligation suggests that as a result of a company’s past business practice, its desire to maintain a good reputation, or even its desire to simply act (and be seen as acting) in an ethical manner, a liability may be created even in the absence of legal enforceability.
Second, the obligation must be the result of a past event. Two common examples of events that would give rise to a liability include the purchase of goods on credit or the receipt of loan proceeds from a bank. The events, which result in economic benefits being delivered to the company, clearly create an obligation. On the other hand, if a company plans to purchase goods in the future, this does not create an obligation, as no event has yet occurred. Although these examples are quite straightforward, we will see later in this chapter that in some situations it is more difficult to ascertain whether a past event has created a present obligation.
The third criterion requires a future outflow of economic benefits. Although we can easily understand the repayment of an outstanding account payable as a use of economic resources, there are other ways that liabilities can be settled that don’t involve the payment of cash. These can include the future delivery of goods or services to customers or other parties. In some cases, there may be difficulties in determining the values of the goods or services to be delivered in the future. We will examine several examples of liabilities that are settled with non-cash resources.
