Obligation: A duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner.
It is important to distinguish between a present obligation and a future commitment. A management decision to purchase assets in the future does not, in itself, give rise to a present obligation.
Settlement of a present obligation will involve the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. This may be done in various ways, not just by payment of cash.
Liabilities must arise from past transactions or events. In the case of, say, recognition of future rebates to customers based on annual purchases, the sale of goods in the past is the transaction that gives rise to the liability.
A present obligation as a result of a past event will not be recognised in the balance sheet as a liability but rather off balance sheet as a contingent liability if and when:
- It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
- The amount of the obligation cannot be measured with sufficient reliability.
The Conceptual Framework explains ‘present obligation as a result of past events’ along some essential features captured in the following subjects:
1. Definition present obligation Present obligation as a result of past event
A present obligation exists as a result of past events only if:
- the entity has already obtained economic benefits or taken an action; and
- as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer.
The past event (for example purchase and receipt of certain inventory goods) has created valid expectations in other parties that the entity will discharge the obligation.
Obligations that will arise from the entity’s future actions (ie the future conduct of its business) do not satisfy the condition above, no matter how likely they are to occur and even if they are contractual.
To illustrate, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a particular type of factory). Because the entity can avoid the future expenditure by its future actions, for example by changing its method of operation or selling the factory, it has no present obligation for that future expenditure and no obligation is present and as a result not recognised.
2 Repeating transactions Present obligation as a result of past event
The economic benefits obtained could include, for example, goods or services. The action taken could include, for example, operating a particular business or operating in a particular market. If economic benefits are obtained, or an action is taken, over time, the resulting present obligation may accumulate over that time.
Many times certain types of transactions are repeatedly entered into as a result of the reporting entity’s business or operations, each transaction results in a new obligation being regonised.
3. Impact of new legislation Present obligation as a result of past event
If new legislation is enacted, a present obligation arises only when, as a consequence of obtaining economic benefits or taking an action to which that legislation applies, an entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. The enactment of legislation is not in itself sufficient to give an entity a present obligation. Similarly, an entity’s customary practice, published policy or specific statement gives rise to a present obligation only when, as a consequence of obtaining economic benefits, or taking an action, to which that practice, policy or statement applies, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer.
The effect of possible new legislation is taken into consideration in measuring an existing obligation when sufficient objective evidence exists that the legislation is virtually certain to be enacted. The variety of circumstances that arise in practice makes it impossible to specify a single event that will provide sufficient, objective evidence in every case. Evidence is required both of what legislation will demand and of whether it is virtually certain to be enacted and implemented in due course. In many cases sufficient objective evidence will not exist until the new legislation is enacted.
4. Present obligation and future transfer of economic benefits Present obligation as a result of past event
A present obligation can exist even if a transfer of economic resources cannot be enforced until some point in the future. For example, a contractual liability to pay cash may exist now even if the contract does not require a payment until a future date. Similarly, a contractual obligation for an entity to perform work at a future date may exist now even if the counterparty cannot require the entity to perform the work until that future date.
A contractual obligation for the entity to perform work at a future date cannot be enforced by the counterparty until that future date, but the obligation arising from the contract exists now if the counterparty has already paid for the work.
5. No present obligation when not received the counterpart economic benefits Present obligation as a result of past event
An entity does not yet have a present obligation to transfer an economic resource if it has not yet satisfied the criteria in the definition of present obligation, that is, if it has not yet obtained economic benefits, or taken an action, that would or could require the entity to transfer an economic resource that it would not otherwise have had to transfer. For example, if an entity has entered into a contract to pay an employee a salary in exchange for receiving the employee’s services, the entity does not have a present obligation to pay the salary until it has received the employee’s services. Before then the contract is executory—the entity has a combined right and obligation to exchange future salary for future employee services (see Executory contracts).
The contracted obligation for steel ordered but not yet received would not generally be recognised as a present obligation/liability in the financial statements.