In order for a liability to be recognized in the financial statements, it must meet the following definition provided by the framework:
A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits (IASB Framework).
As is clear from the above definition, the obligation must be a present one, arising from past events. In case of a bank loan for instance, the past event would be the receipt of loan principal. The obligation to pay off the loan would be present from the day the entity receives the loan principal (i.e. when an obligating event occurs). Conversely, a liability may not be recognized in anticipation of a future obligation such a bank loan expected to be taken in two year’s time.
The obligation to transfer economic benefits may not only be a legal one. Liability in respect of a constructive obligation may also be recognized where an entity, on the basis of its past practices, has a created a valid expectation in the minds of the concerned persons that it will fulfill such obligations in the future. For example, if an oil exploration company has a past practice of restoring oil rig sites after they are dismantled in spite of no legal obligation to do so, and it advertises itself as an environment friendly organization, then this gives rise to a constructive liability and must therefore be recognized in the financial statements of the company. This is because a valid expectation has been created that the company will restore oil rig sites in the future.
Apart from satisfying the definition of liability, the framework has also advised the following recognition criteria to be met before a liability could be shown on the face of a financial statement:
- The outflow of resources embodying economic benefits (such as cash) from the entity is probable.
- The cost / value of the obligation can be measured reliably.
With regard to the first test, it is logical to recognize a liability only if it is likely that the entity will be required to settle it. The second test ensures that only liabilities that can be objectively measured are recognized in the financial statements.
If an obligation meets the definition of a liability but fails to meet the recognition criteria, it is classified as a contingent liability. Contingent liability is not presented as a liability in the statement of financial position but is instead disclosed in the notes to the financial statements.