Accountancy's unsolved riddle - what is a liability?

The concept of a liability presents difficulties when accounting for multi-year grants, says Ray Jones of the Charity Commission

The earliest known accounting records are of temple income in lower Mesopotamia in about 4000 BC.

The art of accountancy developed slowly and we had to wait another 5,500 years before Luca Pacioli, an Italian Franciscan friar and mathematician, wrote the first book on double-entry accounting in 1494.

Pacioli's work has stood the test of time. Double-entry accounting remains the foundation of every accountant's training. Understand this concept, we were told as young articled clerks, and the mysteries of the accounting world will be revealed. Put simply: to have a liability, you must have incurred an expense.

So how does the system apply to charities? According to theory, a liability is something you can't avoid paying. So if you contract for goods or services and receive them, you have no choice but to settle the resulting debt.

But as a charity, do you create a liability when you promise to make a grant payment? There might be no contractual requirement to make the gift, but there will certainly be an expectation that grant-making charities honour their commitments.

The challenge for the charity accountant is how to account for making a promise. Have you created a liability that should be recorded in your charity's accounts?

The Statement of Recommended Practice for charities says that, by promising funding, you have created a "constructive liability" that must be recorded in your accounts. Most, but by no means all, charity accountants agree that's a reasonable approach.

But views start to differ when the promised amount is to be paid over a number of years. If you promise to make a grant of £150,000 over three annual instalments of £50,000, for example, what is your liability?

The Sorp would say that, unless there are conditions that might prevent payment, you have a liability of £150,000 that should be recorded in your accounts.

But some accountants say this overstates liabilities, because future instalments will be paid from future income. Only the instalment to be paid from the current year's income should be shown as a liability, they argue. But if you have to pay off a bank loan of £150,000 over three years, no one would suggest your liability is limited to one year's repayment.

Accountants will continue to argue about the definition of a liability, especially as the Accounting Standards Board and Sorp Committee start their work this month on the proposed Public Benefit Entity Standard and the next Sorp.

Ray Jones is policy accountant at the Charity Commission

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