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 (Barton, 2014).

The capital invested by the owner or shareholders in an enterprise is not regarded as a liability in accounting. We shall deal with the accounting treatment of the owner's or shareholders' equity presently,-but we should mention at this stage that 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' (Barton 2014). 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.


Interested in Consolidated Income Statements

Read on: Goodwill

Goodwill

Goodwill may be described as the sum of those intangible attributes of a business which contribute to its success, such as a favourable location, a good reputation, the ability and skill of its employees and management, its long-standing relationships with creditors, suppliers and customers. The valuation of goodwill is a controversial topic in accounting because of its vague nature and the difficulty of arriving at a valuation which is verifiable. Hence, in view of its lack of accounting objectivity, it is generally excluded from the balance sheet. Goodwill only enters the accounting... see: Goodwill