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Accounting Horizons American Accounting AssociationVol. 24, No. 4 DOI: 10.2308/acch.2010.24.4.6232010pp. 623–633

hat Are the Essential Features of a Liability?

Dennis Murray

SYNOPSIS: The Financial Accounting Standards Board �FASB� and the InternationalAccounting Standards Board �IASB� are in the process of jointly re-examining theirconceptual frameworks. The re-examination includes assessing the definition of a liabil-ity. The Boards’ existing liability definitions include three criteria: �1� a present obliga-tion; �2� a past transaction or event; and �3� a probable future sacrifice of economicbenefits. The Boards have recently proposed that a liability be defined as “a presentobligation for which the entity is the obligor” �FASB 2008c, 2�. The proposed definitionmentions only one time dimension �the present�. References to the past and future areomitted. This paper argues that these omissions are undesirable. Omitting a referenceto the past removes the link between the definition and the tradition of historically basedfinancial statements. More importantly, however, the failure to reference future sacri-fices of economic benefits divorces the definition from the primary objective of financialreporting: to provide information about the “amount, timing and uncertainty of an entity’sfuture cash flows” �FASB 2008a, para. OB6�. This paper offers an alternative definitionthat emphasizes the past and future rather than the present.

INTRODUCTIONhe Financial Accounting Standards Board �FASB� and the International Accounting Stan-dards Board �IASB� are in the process of re-examining their conceptual frameworks. Thegoal is for the Boards to jointly issue a common framework that would underlie the

eliberations of both bodies. The framework will delineate the objectives of financial reporting,dentify the qualitative characteristics of decision-useful information, define the elements of finan-ial statements and address recognition and measurement issues �FASB 2006�.

The Boards are considering substantive changes to the definition of a liability. The changes, ifmplemented, could significantly affect the particular obligations included in financial statementsnd, ultimately, the usefulness of those statements. The purpose of this paper is to review andritically evaluate the newly proposed liability definition. While the definition itself is of primarynterest, issues related to recognition and measurement will be addressed in a limited fashion.

In order to conduct the analysis, one presumption will be made. The tentative conclusionsbout the objective of financial accounting reached by the Boards will be accepted. The Boardsaintain that:

The objective of general purpose financial reporting is to provide financial information about thereporting entity that is useful to present and potential equity investors, lenders, and other creditorsin making decisions in their capacity as capital providers. �FASB 2008a, para. OB2�

ennis Murray is a Professor at the University of Colorado at Denver.

am grateful for the helpful comments of two anonymous reviewers.

Submitted: February 2009Accepted: June 2010

Published Online: December 2010Corresponding author: Dennis MurrayEmail: Dennis.Murray@ucdenver.edu

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The Boards further maintain that both equity investors and lenders “are interested in themount, timing, and uncertainty of an entity’s future cash flows” �FASB 2008a, para. OB6�. Theoards have taken a strong decision usefulness orientation. The envisioned decisions involve thellocation of resources �e.g., investing and lending� that are made by investors and creditors. Inaking these decisions, investors and creditors assess an entity’s ability to generate net cash

nflows. To assist in making this determination, financial reporting is to provide, among otherhings, information about claims to an entity’s resources �FASB 2008a, para. OB6�. Thus, theajor criterion used in this paper to evaluate the desirability of a liability definition is the degree

o which it can assist financial statement users in assessing the cash flows needed to satisfy thelaims of creditors.

EXISTING DEFINITIONSThe FASB’s existing liability definition is contained in Statement of Financial Accounting

oncept �SFAC� No. 6, Elements of Financial Statements:

Liabilities are probable future sacrifices of economic benefits arising from present obligations of aparticular entity to transfer assets or provide services to other entities in the future as a result of apast transaction or event. �FASB 1985a, para. 35�

he existing IASB definition is contained in Framework for the Preparation and Presentation ofinancial Statements:

A liability is a present obligation of the entity arising from past events, the settlement of which isexpected to result in an outflow from the entity of resources embodying economic benefits. �IASB2001, para. 49�

ach definition contains essentially the same components, although the sequencing and exacthraseology differ slightly. Both definitions reference �1� present obligations, �2� past events, and3� a future conveyance of economic benefits. Present obligations refer to responsibilities or dutieshat exist on the balance sheet date. Present obligations are viewed as leaving the entity “little oro discretion” �FASB 1985a, para. 36�. Both the FASB and IASB believe that constructive orquitable obligations meet their definitions. Constructive or equitable obligations arise from cus-om or potential social sanctions rather than from legal compulsion. Examples include productarranty costs arising from customary practice rather than formal warranties �IASB 2001, para.0� and vacation pay obligations not supported by contract �FASB 1985a, para. 40�.

Both definitions refer to past events. This reference acknowledges that financial statements areistorically based. The Boards have stated that financial reporting information is based on “thenancial effects on an entity of transactions and other events and circumstances that have hap-ened or that exist” �FASB 2008a, para. OB14�. Accountants have become accustomed to search-ng for past transactions or events to trigger the recognition of financial statement items.

Both definitions also look to the future. The FASB references “probable future sacrifices ofconomic benefits.” The IASB definition includes the phrase “expected to result in an outflowrom the entity of resources embodying economic benefits.” Economic benefits are items that havehe capacity to result in net cash inflows �FASB 1985a, para. 27�. Both definitions anticipate thentity’s conveyance of such benefits to an outside party at a date in the future. However, neitherefinition demands that the anticipated conveyance be certain. The FASB uses the term probable,hich “refers to that which can reasonably be expected or believed on the basis of available

vidence or logic” �FASB 1985a, para. 35�. The IASB has indicated that its term expected has theame meaning as the term probable �IASB 2008a�. Storey and Storey �1998� report that the FASBncluded the term probable in the liability definition because of concerns that its omission wouldequire the anticipated outflow to be virtually certain, resulting in the recognition of many feweriabilities than is presently the case.

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PROPOSED DEFINITIONThe Boards have proposed the following definition:

A liability of an entity is a present economic obligation for which the entity is the obligor. �FASB2008c, 2�

he proposed definition contains two provisions: �1� that a present economic obligation exists and2� that the entity is the obligor. An economic obligation is an unconditional promise or otherequirement to provide economic resources �FASB 2008c�. The term present indicates that thebligation exists on the balance sheet date. No mention is made of past transactions or futureacrifices; the focus is exclusively on the present. The necessity of identifying past triggeringransactions or events is obviated. Additionally, future outcomes do not play a role. Forecasts orxpectations are not a factor. An entity simply must identify the obligations it has on the reportingate. The Boards have also tentatively decided that liabilities should be unconditional. “An un-onditional obligation requires performance to occur now or over a period of time, whereas aonditional obligation requires performance to occur only if an uncertain future event occurs”FASB 2008b, 8�.

The second provision of the proposed definition requires that the entity be the obligor. Thisndicates that the “obligation is enforceable by legal or equivalent means” against the entityFASB 2008c, 3�. FASB staff has indicated that this phrase is intended to imply that constructivebligations should be viewed as liabilities �FASB 2008c�.

ANALYSIS OF PROPOSED DEFINITIONThe proposed definition is markedly different from the existing definitions. The proposed

efinition is shorter and simpler. It mentions only the present, instead of referencing three timeimensions �past, present, and future�. The simplicity and the focus on the present are appealingttributes. However, does a singular focus on the present yield information that compromises thebility of financial statement users to assess the amounts, timing, and uncertainty of the entity’suture cash flows? Is an emphasis on present obligations to the exclusion of probable futureacrifices desirable? Are constructive obligations really enforceable? Should probability thresholdsor recognition be abandoned? The following subsections address these questions.

onstructive ObligationsThe proposed definition and additional commentary provided by the FASB indicate that a

iability must be an obligation that is enforceable by legal or equivalent means. A legal obligationrises �1� from a law, statute, or ordinance, �2� from a written or oral contract, or �3� via promis-ory estoppel �FASB 2001, para. 2�. Promissory estoppel is the doctrine that a promise madeithout consideration may be legally enforceable if the promisor should have reasonably expected

he promisee to rely on the promise and the promisee did in fact rely on the promise to his or heretriment �Garner and Black 2009�. Note, in particular, that promissory estoppel is a method tochieve legal enforcement.

Beyond legal compulsion, by what “equivalent means” can an obligation be enforced? Con-tructive obligations are presumably “binding primarily because of social or moral sanctions orustom” �FASB 1985a, para. 40�. How can social or moral sanctions or custom be used to enforceconstructive obligation?

Consider unvested pension benefits. Statement of Financial Accounting Standard �SFAS� No.7, Employers’ Accounting for Pensions �FASB 1985b�, and International Accounting StandardIAS� 19, Employee Benefits �IASB 2007�, both require recognition of liabilities for pensionenefits that have been earned but remain unvested as of the reporting date. The entity is notegally obligated to honor these benefits. Can employees enforce the obligation for unvestedenefits by non-legal means? The Pension Benefit Guaranty Corporation �PBGC� provides impor-ant information on this question. PBGC �2008� reports that of the single-employer plans that it

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nsured in 2003, 2004, and 2005, 9.5 percent, 12.1 percent and 14.1 percent, respectively, had aard-freeze in place.1 By hard-freezing a plan, earned but unvested benefits will not be paid.nvested benefits based on future salary progression will also not be paid. Thus, it appears that in

ome cases unvested benefit obligations may not be enforceable, thereby disqualifying them asiabilities under the proposed definition.2

The FASB’s existing rationale for viewing unvested pension benefits as liabilities is revealing.he going concern assumption is invoked as implying that a pension plan will continue in opera-

ion �in the absence of evidence to the contrary� and that benefits will be paid. “Benefits that arexpected to vest are probable future sacrifices, and the liability in an ongoing plan situation is notimited to vested benefits” �FASB 1985b, para. 149�. Notice that the argument is not that the entitys presently obligated. The argument underlying the view that an unvested pension benefit is aiability is that the sacrifice is probable. However, the liability definition proposed by the FASBnd IASB does not contain the criterion of probable future sacrifice. Thus, if the proposed defi-ition is adopted, the Boards must develop an alternative rationale to justify treating unvestedension obligations as liabilities.

However, unvested pension benefits are likely associated with future cash flows �if not on anndividual employee basis, certainly on a workforce wide basis�. Assuming that actuarial estimatesre sufficiently reliable, financial statement recognition of this obligation may provide informationelpful in assessing an entity’s future cash flows to employees. Barth �1991� shows that theccumulated benefit obligation �ABO�, which includes unvested benefits, is more consistent withecurity prices �i.e., assessments of future cash flows� than the vested pension obligation �VBO�,hich includes only vested benefits. Requiring a liability to be a presently enforceable obligationay not, therefore, be desirable if the goal is to provide information that assists in assessing the

mount, timing and uncertainty of an entity’s future cash flows.

nconditionalityAnother important issue is that of unconditionality. The Boards have tentatively concluded

hat obligations must be unconditional in order to qualify as liabilities. Recall that unconditionalbligations are not contingent on the occurrence of future events. Consider how product warrantiesould be viewed in this context. Payments on product warranties are conditional on a future event:roduct failure. Without product failure, no economic resources will be conveyed. Therefore,ccording to the proposed definition, product warranties would not meet the definition of a liabilityntil failure has occurred. At the time of sale, the proposed definition would not be met, and noiability would exist or be reflected on the balance sheet. Given that warranties on products thatave been sold but have not yet failed are likely associated with future payments to correctefective products, excluding this obligation from the balance sheet would not assist financialtatement users in assessing an entity’s future cash flows.

Now consider conditional asset retirement obligations �AROs�. FASB Interpretation �FIN�o. 47, Accounting for Conditional Asset Retirement Obligations �FASB 2005�, defines a condi-

ional ARO as “a legal obligation to perform an asset retirement activity in which the timing andor� method of settlement are conditional on a future event that may or may not be within theontrol of the entity” �FASB 2005, para. 3�. FIN No. 47 assumes a situation where “�t�he obliga-ion to perform the asset retirement activity is unconditional even though uncertainty exists abouthe timing �or� method of settlement” �FASB 2005, para.3�. The term conditional is being usedifferently in the proposed definition and in FIN No. 47. In the proposed definition, conditional

A hard-freeze suspends new benefit accruals with respect to both service and compensation levels.An alternative interpretation is that employees elected not to enforce the unvested obligations.

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efers to the existence of the obligation. That is, the proposed definition requires that the obligationot be conditional on a future event. This is why product warranties do not meet the proposedefinition: they are conditional on a future event �product failure�. The issue is the existence of thebligation, not its measurement. FIN No. 47 deals with a situation where the existence of thebligation is unconditional, but the method of settlement and, therefore, the associated costs areonditional on future events. Consider the example of a nuclear power plant where the operatingicense includes a requirement for decommissioning. The decommissioning obligation arises asoon as the plant begins operations. However, the method used to decommission the plant willepend on the technology available at the time of decommissioning, as well as other factors.ncertainty exists about the method of settlement and associated costs because they are condi-

ional on future technology. The issue in FIN No. 47 is measurement of the obligation, not itsxistence.

I believe that conditional AROs would be viewed as liabilities under the proposed definition.onditional AROs are actually unconditional obligations, if one uses the meaning of unconditional

n the proposed liability definition. If the measurement issues are such that a reasonable estimatef the obligation can be made, the obligation would be recognized. In contrast, the existence of aroduct warranty liability is conditional on an uncertain future event �product failure� even if theethod of settlement is known with virtual certainty. The difference between product warranties

nd conditional AROs underscores the importance of clearly distinguishing definitional issuesrom measurement issues.

The Boards apparently recognize the undesirability of the product warranty result and havereated the notion of a stand-ready obligation.3 In the product warranty situation, the entity isiewed as having �1� an unconditional obligation to stand-ready to perform if product failureccurs and �2� a conditional obligation to correct a defect if product failure occurs. While theoards acknowledge that a stand-ready obligation is passive, they believe that it is a genuinebligation that arises at the time of sale and should be recognized at that point. The responsibilityo actually honor the warranty by repairing or replacing a defective product is viewed by theoards as a conditional obligation prior to product failure, which would not meet the proposed

iability definition at the time of sale. At the time of failure, the obligation to repair or replace thenecomes unconditional and recognition of this liability would then be appropriate.

IASB �2005� has addressed the measurement of stand-ready obligations. It recommends thatstand-ready �unconditional� obligation be measured at a settlement amount �i.e., an amount the

ntity would be required to pay a third party to relieve itself of the obligation�. In the productarranty situation, because a third party would consider the likelihood that it would ultimately be

alled upon to remedy a product failure, the measurement of the stand-ready obligation wouldeflect the likelihood of product failure and the associated costs. That is, the measurement of thenconditional stand-ready obligation would reflect the third party’s assessment of its obligation toonor the obligation for actual repairs, which is conditional on product failure.

The passive nature of a stand-ready obligation is of paramount importance. What sacrifice iseeded to honor a stand-ready obligation? That is, what sacrifice is needed to provide risk pro-ection prior to product failure? None. I can stand-ready all day, every day and it will cost meothing. With no conveyance of economic benefits, no economic obligation exists. Thus, a stand-eady obligation is not really an economic obligation and is not a liability. The notion of atand-ready obligation is simply a contrivance by the Boards. The contrivance is needed becausehe proposed liability definition does not yield sensible, useful results. The proposed definition

The concept of a stand-ready obligation has been most extensively developed by the IASB in its reconsideration of IAS37, Provisions, Contingent Liabilities and Contingent Assets �IASB 2005�.

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emands that an unconditional enforceable obligation exists on the balance sheet date. Productarranty obligations do not meet this standard because they are conditional on a future event:roduct failure. Yet virtually all accountants view these obligations as liabilities, and with goodause. They are likely associated with future cash flows. To obtain a desirable result, the Boardsave artificially bifurcated certain obligations into a conditional obligation and an unconditionaltand-ready obligation that is associated with no flow of economic resources.

Given that no sacrifices of economic benefits are associated with stand-ready obligations, theirecognition would presumably result in no increase in measured liabilities. This perhaps is, at leastn part, the motivation for the measurement rules suggested in IASB �2005�, which propose these of a third party settlement amount. A third party settlement amount would include an assess-ent of the expected future cash flows associated with the conditional obligation tied to product

ailure. Therefore, the proposed measurement rules for the unconditional stand-ready obligationesult in the recognition of the expected cash flows associated with the unrecognized conditionalbligation. That is, according to the FASB and IASB’s proposed definition and measurement rules,he obligation for product repair that is contingent on product failure should not be recognizedecause it is conditional on a future event �i.e., product failure�. Moreover, the Boards propose thathe recognized unconditional stand-ready obligation be measured by a settlement amount thateflects the expected cash flows associated with the unrecognized conditional obligation, a seem-ngly incongruous outcome. Without the stand-ready contrivance and the associated measurementules �which incorporate the expected cash flows from the conditional obligation�, product war-anties would not meet the proposed definition and no product warranty obligation would appears a liability on balance sheets prior to product failure.

hresholds versus Expected ValuesSFAS No. 143, Accounting for Asset Retirement Obligations �FASB 2001�, provides another

nstructive illustration about the FASB’s approach to liability recognition and measurement. SFASo. 143 provides an example of a governmental unit retaining the right to require a retirement

ctivity. The FASB concludes that “Uncertainty about whether performance will be required doesot defer the recognition of a retirement obligation; rather, that uncertainty is factored into theeasurement of the fair value of the liability through assignment of probabilities to cash flows”

FASB 2001, para. A17�. Thus, the FASB has moved from a threshold approach for liabilityecognition to an expected value approach. The FASB ignored the probability criterion in thexisting liability definition. That is, a minimal level of likelihood is not required for recognition ofsset retirement obligations. Rather, uncertainty is incorporated in the measurement of the liability,ven if the likelihood of the sacrifice is extremely low.4

A recent survey by PricewaterhouseCoopers �PwC 2007� provides some evidence about fi-ancial statement users’ views of this issue. Buy-side and sell-side investment professionals andnvestors across four countries �Canada, Germany, U.K., and U.S.� were interviewed �PwC 2007�.5

ighty-six percent of those surveyed support recognizing liabilities only when the outflow isikely. Curiously, 96 percent prefer a measurement model based on probability-adjusted dis-ounted cash flows. Whereas the Boards appear to view thresholds and expected values as alter-atives to dealing with uncertainty, the financial statement users interviewed in PwC �2007� preferhat these approaches be used jointly. However, more to the point of the present discussion, thewC �2007� respondents clearly favor retaining a probability threshold for liability recognition.his preference is inconsistent with the Boards’ reliance on expected values.

See Johnson et al. �1993� for a discussion of thresholds and expected values.Given the sampling approach employed, PwC cautions that its results should not be viewed as statistically valid.

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robable Future SacrificeThe previous subsections suggest that a weakness in the proposed definition may well be its

ocus on the present. Given that financial reporting is intended to help users assess an entity’suture cash flows, the likelihood that an outflow of resources will ensue from an arrangement isritical. The existing FASB liability definition uses the phrase “probable future sacrifices,” whilehe proposed definition makes no reference to the future. Instead, the proposed definition requires

presently enforceable economic obligation. This requirement is too exclusionary. That is, nu-erous probable future sacrifices �e.g., unvested pension benefits and product warranties� would

ail to meet this requirement and be excluded from balance sheets. By ignoring the future, theroposed definition fails to meet the Boards’ stated goal of providing information useful in as-essing an entity’s future cash flows.

The proposed definition also does not reference the past. This fails to acknowledge thatusiness transactions often unfold over time, rather than occur at discrete points in time. Both thenvested employee benefits illustration and the product warranty illustration are good examples ofransactions that can easily take years to complete. A key question is: when during a possiblyxtended arrangement should the liability definition be considered fulfilled?

To summarize, a liability definition that demands the existence of an unconditional, enforce-ble present obligation will omit from the balance sheet numerous probable future sacrifices ofconomic benefits. These omissions will compromise the ability of financial statement users tossess an entity’s future cash flows. Moreover, a liability definition should also provide guidanceegarding the many transactions that require an extended period of time to complete.

AN ALTERNATIVEConsider a definition that emphasizes future sacrifices and the possibly prolonged nature of

ome relationships and transactions:

A liability is a likely future sacrifice of economic benefits arising as the result of events andtransactions that have largely been completed.

he Boards’ stated objective of financial statements is to help users assess an entity’s future cashows. Accordingly, the first component of the definition refers to a likely future sacrifice ofconomic benefits. If an item is not reasonably associated with a future cash outflow, its treatments a liability would not be helpful to users in assessing those flows. Therefore, such an associations a necessary condition of a liability.

Given that future events are referenced in the definition, the qualifier likely is used in recog-ition of the uncertainty surrounding the future. The existing FASB liability definition includes theerm probable with the meaning of reasonably expected. The FASB also uses the term probable inFAS No. 5, Accounting for Contingencies �FASB 1975�. In that standard, probable is used withdifferent meaning; it is defined as likely to occur. At the very least, communication is hamperedy having two definitions for one term. To distance my alternative definition from the resultingonfusion, I have chosen the term likely rather than probable.

What meaning should be attached to likely? In IAS 37, the IASB defines probable as “moreikely than not to occur” �IASB 2008b, para. 23�. That is, recognition as a liability would requiregreater than 50 percent probability of occurring. I adopt this meaning for several reasons. First,

he meaning is simple and easy to understand. It can be thought of as either a probability or oddsi.e., better than even odds�. It is concrete �at least in terms of basic conceptualization�, unlike thexisting FASB definitions of probable. Additionally, a 50 percent threshold is not far from users’references, as documented by Aharony and Dotan �2004�. The financial analysts participating inheir study attached an average probability level of 65 percent to the term probable �as used inFAS No. 5�. Thus, a 50 percent threshold would be a bit more conservative than the averagereference of these analysts.

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While a 50 percent threshold is quite specific in concept, both the Boards and practitionersould need to use judgment when applying this definition. Judgment would be needed by theoards in developing specific financial accounting standards. For example, the Boards mightonclude that unvested pension benefits meet the threshold, but guarantees of the indebtedness ofthers do not. Practitioners would also need to exercise judgment in applying the threshold toituations left unaddressed by the Boards �e.g., litigation�.

The second component of the definition requires that the future sacrifice be due to events andransactions that have largely been completed. This aspect of the definition is consistent withistorically based financial statements. In particular, it recognizes that a probable future sacrifice isecessary but not sufficient for the existence of a liability. At a given point in time, an entity willave many plans and expectations that will likely result in future sacrifices of economic benefits.xamples include plans for the purchase of goods and services, future capital expenditures and thenticipated payment to employees for services that have not yet been rendered. Inclusion in thenancial statements of the expected cash flows associated with these plans would mark a signifi-ant departure from traditional historically based financial statements. Accordingly, the secondomponent of the definition reinforces the historical nature of accounting and excludes fromiabilities cash flows associated with an entity’s plans for future transactions.

The second component also acknowledges that events, transactions, situations, and relation-hips can take time to complete. Ijiri �1980� examined the recognition issue with respect toontractual rights and obligations. Using the example of a non-cancellable commodity purchaseontract, Ijiri �1980� identified five possible liability recognition points for the buyer: �1� contractoint—when the contract is signed, �2� procurement point—when the seller procures the product,3� production point—when the seller completes processing the product, �4� segregation point—hen the seller segregates the product prior to shipment, and �5� delivery point—when the sellerelivers the product to the buyer. Ijiri �1980� suggests that the delivery point might signal aufficient increase in the likelihood that the obligation will be fulfilled to warrant recognition.pecification of delivery as the recognition point seems too detailed for the definitional level.owever, Ijiri �1980� directs attention to a critical question: when has a relationship sufficientlyrogressed to warrant recognition?

The definition that I offer requires that the future sacrifice be the result of events and trans-ctions that have largely been completed. The existing definition references past transactions andvents, to some degree implying a binary characterization: transactions and events are in the pastr they are not. The phrase “largely been completed” explicitly recognizes that transactions andvents might be partially complete on the reporting date. The term largely requires that the bulk ofhe obligating event�s� must have already occurred. Current generally accepted accounting prin-iples take a similar approach, particularly with respect to revenue recognition. For example,FAS No. 45, Accounting for Franchise Fee Revenue �FASB 1981a�, provides that revenue shalle recognized when services have been substantially performed. Similarly, SFAS No. 48, Revenueecognition When Right of Return Exists �FASB 1981b�, establishes as a condition for revenue

ecognition that the seller does not have significant future performance obligations. These stan-ards address specific situations where the relationship between the parties evolves over time.udgment will be needed in applying fundamental concepts and definitions to specific settings. Theefinition I offer provides the Boards reasonable guidance and flexibility when setting standardsddressing particular liabilities.

xamplesHow would unvested pension benefits and product warranties be evaluated in terms of my

uggested definition? On a workforce-wide basis, unvested pension benefits are likely associatedith future cash flows, thereby meeting the first component of the definition �i.e., a likely future

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acrifice�. Are these benefits due to events and transactions that have largely been completed?nvested �but earned� pension benefits result from services that have already been rendered, but

he actual payment is contingent upon continued employment for a specified period. Judgment islearly necessary to answer this question. My judgment would be in the affirmative. The serviceshat underlie the determination of the benefits have been rendered. While additional services areeeded in order for payment to be compulsory, the amount of the payment will be unaffected byhe additional years of service. Although different people may render different judgments, theefinition directs attention to the important questions.

Product warranties, as a group, are also very likely associated with future cash flows, therebyeeting the first component of the definition. Are they due to events and transactions that have

argely been completed? Assume that the sale of the underlying product has occurred, the revenueas been recognized, but product failure has not occurred. Although the product has not yet failed,he production process has been completed and the inherent quality of the product has beenstablished. My conclusion would be that the product warranty transaction is largely completed athe time of sale, thereby justifying the view that product warranties are liabilities. Note thatroduct warranties would not meet the Boards’ proposed definition because they are conditionaln a future event �product failure�.

Consider two final examples. The first example involves a lessee’s obligation for a contingentental. Assume that on July 1 a calendar year-end entity signs a one-year store lease for a fixedum plus an additional fixed sum if a sales threshold is met. Also assume that as of December 31he sales volume is 95 percent of the threshold and every expectation is that sales will continue toe strong. Does a liability exist on December 31? According to my proposed definition, a liabilityoes exist. The future sacrifice is likely and the events and transactions underlying the liability are5 percent complete. According to the Boards’ proposed definition, a liability does not existecause the obligation is conditional on a future event �additional sales�. Therefore, according tohe Boards’ proposal, this very likely cash outflow would be omitted from the balance sheet,hereas under my proposal, it would be reflected on the balance sheet.

The above three examples have a common thread. They involve a likely future sacrifice thats due to events and transactions that have largely been completed. However, the future sacrifice isonditional on future events �i.e., a present obligation does not exist�. Consequently, those situa-ions meet my proposed liability definition, but not the definition proposed by the Boards.

The next example is based on material in SFAS No. 143. Assume an entity leases a tract ofand for the purpose of harvesting timber. The lease gives the lessor the option to require the lesseeo reforest the land. Also assume that given the lessor’s past history, the likelihood that reforesta-ion will be required is 10 percent. Does a liability arise as harvesting takes place? According to

y proposed definition, a liability does not exist because the cash outflow is not likely. Accordingo the Boards’ proposed definition, the entity has a liability because a present obligation exists.herefore, according to the Boards’ definition, this extremely unlikely cash outflow would be

ecorded as a liability on the balance sheet. The uncertainty is reflected in the measurement bysing an expected cash flow figure, rather than using a probability threshold for recognition.

Let’s contrast the last two examples. The contingent rent in the store lease is a highly likelyuture cash outflow that is due to events that have largely taken place. My alternative definitionould reflect this obligation on the balance sheet, whereas the Boards’ proposal would not because

he entity is not presently obligated. The ARO for reforestation is highly unlikely to materializend, accordingly, does not meet my proposed definition. However, this ARO does meet theoards’ definition because a legal obligation exists, even though the likelihood of future cashutflows is small. In my view, a flaw in the Boards’ definition is that some likely cash outflowsould not be considered liabilities and some unlikely cash outflows would be considered liabili-

ies. I do not believe that this would result in improved financial reporting.

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SUMMARYThe existing liability definitions promulgated by the FASB and IASB reference three time

imensions: past, present and future. The Boards’ proposed definition does not reference the pastr future, instead focusing on present, enforceable obligations. Many obligations �e.g., bank loansnd purchases on account� clearly are present, enforceable obligations. However, meeting thetandard of a present, enforceable obligation can be challenging in some settings, such as unvestedension benefits and product warranties. In those situations, a present, enforceable obligation doesot exist and no liability should be reported under the Boards’ proposed definition. This resultonflicts with the existing treatment of these items, and would compromise users’ ability to assessn entity’s future cash flows. While a liability definition that focuses on present obligations hasppeal, an emphasis on the present drives a wedge between the definition and the use to whichnancial statement information will be put: assessing future cash flows.

Consequently, I propose a definition that emphasizes a probable future sacrifice of economicenefits coupled with the requirement that the events and transactions underlying the future sac-ifice have largely been completed. The latter requirement retains the historical nature of financialeporting, assures that the balance sheet is not cluttered with an entity’s future plans, and accom-odates the extended nature of some arrangements while the link to the future helps assure that

he objectives of financial reporting will be met.I understand the Boards’ motivation for focusing on the present, rather than the past and

uture. However, doing so destroys the link between the liability definition and the objective ofnancial reporting, thereby compromising the usefulness of financial statement information.

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—–. 2008c. Minutes of the October 20, 2008 Board Meeting. Available at: http://www.fasb.org/board_meeting_minutes/10-20-08_cf.pdf.

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