10
An Chapter overview of
accounting for liabilities
.
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10-1
Objectives of this lecture
Know the definition of a liability and understand
how to apply the recognition criteria provided in
the AASBs Framework for the Preparation and
Presentation of Financial Statements
Understand what a contingent liability represents
and understand how it should be disclosed
within the notes to a reporting entitys financial
statements
Understand which provisions should be treated
as liabilities
.
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Objectives (cont.)
Understand why, with certain transactions,
professional judgment is required to determine
whether the transaction gives rise to a liability or
an item of owners equity
Understand some of the reasons why firms
would typically prefer to disclose a transaction as
part of owners equity, rather than as a liability
Understand how to calculate the issue price of
securities such as debentures
Know how to account for any premium or
discount that arises on the issue of debentures
.
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Relevant standards and guidance
AASB 137 Provisions, Contingent Liabilities and
Contingent Assets
AASB 101 Presentation of Financial Statements
AASB 132 Financial Instruments: Presentation
AASB 139 Financial Instruments: Recognition and
Measurement
The AASBs Framework for the Preparation and
Presentation of Financial Statements (the AASB
Framework)
.
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Liabilities defined
AASB 137 defines a liability as:
a present obligation of the entity arising from past
events, the settlement of which is expected to result
in an outflow from the entity of resources embodying
economic benefits
The above is equivalent to the definition
provided in the AASB Framework
Three components of the liability definition
1. There must be a future disposition of economic
benefits to other entities
2. There must be a present obligation
3. A past transaction or other event must have created
the obligation
.
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Liabilities defined (cont.)
As we can see from the definition, a central
aspect of a liability is the existence of a present
obligation
Present obligation
A duty or responsibility to act in a certain way
Might be legally enforceable, e.g. binding contracts or
statutory requirements
Might also arise from normal business practice,
custom and a desire to maintain good relations or act
equitably, e.g. repairing faulty goods outside of
warranty periods
.
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Liabilities defined (cont.)
For a liability to be recognised and disclosed in
the balance sheet (the AASB Framework):
it must be probable that a sacrifice of economic
benefits will be required, and
the amount of the liability must be able to be reliably
measured
Where the entity retains discretion to avoid
making any future sacrifice of economic benefits
a liability does not exist and is not recognised
Some professional judgment might be required
to determine if a liability should be recognised
.
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Contingent liabilities
Contingent liabilities are:
obligations only payable contingent upon a future
event, or
present obligations not currently deemed to be
probable or not measurable with sufficient
reliability
Examples include guarantees to cover
another organisations debts or potential
obligations from legal actions
.
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Contingent liabilities (cont.)
It would be inappropriate to recognise them on the
statement of financial position (balance sheet)
Disclosure of contingent liabilities is relegated to the
notes to the financial statements
Appendix B to AASB 137 provides a useful decision
tree for determining whether a transaction or event
should be recognised as a provision and therefore
included within the statement of financial position, or
disclosed as a contingent liability within the notes to
the financial statements. The decision tree is
reproduced on the following slide
.
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.
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Classification of liabilities as current or noncurrent
Entities may choose how to disclose their liabilities
on the basis of (AASB 101):
a current/non-current dichotomy, or
the order of liquidity
The method chosen must provide more relevant and
reliable information (par. 60 of AASB 101)
Current liabilities are not restricted to those payable
within 12 months if reference is being made to the
entitys normal operating cycle
.
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Classification of liabilities as current
or non-current (cont.)
Current liabilities (AASB 101) are liabilities that
satisfy any of the following criteria:
Expected to be settled in the entitys normal operating
cycle
Held primarily for trading purposes
Due to be settled within 12 months after reporting date
Liabilities in respect of which the entity does not have an
unconditional right to defer settlement for at least 12
months after the reporting period
Non-current liabilities (AASB 101) are:
all liabilities that do not satisfy the criteria for defining
current liabilities
.
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Liability provisions
Defined as a liability of uncertain timing or amount
(AASB 137)
Therefore if something is disclosed as a provision
this should alert the reader to the uncertainties
inherent in its ultimate payment
Traditionally, a number of provisions were included
as liabilities on balance sheets
For example, provisions for employee
entitlements and maintenance and warranty
repairs
Now, if amounts are provided for future
expenditure but there is no obligation to an external
party:
they may not be recognised as liabilities
.
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Liability provisions (cont.)
Only obligations arising from past events existing
independently of an entitys future actions may be
recognised as provisions
For example, penalties for unlawful environmental damage
Measurement of provisions (AASB 137)
The best estimate of the expenditure required to settle the
present obligation at the reporting date
If materially different from its undiscounted value, the
provision must be recognised at its present value
.
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Liability provisions (cont.)
Provisions must be reviewed at each reporting date
(AASB 137)
Where a change in the carrying amount of a
provision is due to the impact of using present
values, AASB 137 requires the change to be
recognised as a borrowing cost specifically,
paragraph 60 states:
where discounting is used, the carrying amount of a
provision increases in each period to reflect the passing of
time. This increase is recognised as a borrowing cost
.
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Some implications of reporting liabilities
How liabilities are measured and disclosed will
affect contractual arrangements tied in part to
liabilities
For example, debt-to-asset constraints
It is hypothesised that managers in organisations
close to breaching debt covenants will choose
accounting methods that:
increase income (thereby assets and owners equity),
or
decrease debt
Whether or not particular accounting methods are
adopted willit has been hypothesisedbe
influenced by the costs of breaching debt covenants
.
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Debtequity debate
All things being equal, firms typically prefer to
disclose low levels of debt
When faced with a need for additional funds,
firms might issue debt-like securities labelled as
equity
For example, redeemable preference shares
Associated distributions are termed dividends (i.e.
distributions of profits), not expenses
If securities are defined as debt:
associated payments are treated as interest, therefore
occasioning a reduction in profits
.
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Debtequity debate (cont.)
AASB 132 Financial Instruments: Presentation
substance The rather than the legal form of a financial
instrument governs its classification on the balance
sheet
Therefore some preference shares are financial
liabilities
Requirement to treat preference shares as debt can have
significant implications for debt-to-assets ratio
Refer to Worked Example 10.3 (p. 342)Impact of
classifying preference shares as debt, rather than equity
.
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Accounting for debentures
Debentures
A written promise to pay a principal amount at a
specified time in the future, as well as interest
calculated at a specified rate
Also referred to as bonds
Typically secured over the assets of the entity issuing
the debenture
May be issued at par, at a discount or at a premium
.
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Debentures issued at par
Par (or face) value
The amount that the debenture holders will receive on
maturity of the debentures
Investors will pay par if the interest rate offered
(coupon rate) accurately reflects what they
believe the interest rate should be
Refer to Worked Example 10.4 (p. 343)Issue
of debentures at par value
.
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Debentures issued at par (cont.)
Issue of debentures
Debit
Credit
Debit
Credit
Cash at bank
Cash trust
Debit
Credit
.
Cash trust
Applicationdebentures
Applicationdebentures
Debentures
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Debentures issued at par (cont.)
Payment of interest
Debit
Credit
Interest expense
Cash at bank
Redemption of debentures
Debit
Credit
.
Debentures
Cash at bank
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Debentures issued at a discount
If the market requires a rate of return in excess
of the coupon rate:
the issue price must be discounted to a price at which
the cash flows to the investor represent the rate of
return required by the market, i.e. debentures issued
at a discount
The present value of the future receipts,
discounted to the markets required rate of
return, needs to be calculated
Refer to Worked Example 10.5 (p. 345)
Debentures issued at a discount
.
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Debentures issued at a discount (cont.)
Issue of debentures (assume direct private
placement)
Debit
Debit
Credit
.
Cash at bank
Discount on debentures
Debentures
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Illustration: Debentures issued at a
discountWorked Example 10.5
Company C issues $10m, 5 year, 10% semi-annual
coupon debentures on 30 June 2012. Assume that
the market requires 12% for the debentures
.
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What would be the issue price?
Present value of interest payments
$500 000 for 10 periods @ 6%
$500 000 x 7.3600866 =
$3 680 043
Present value of principal repayment
$10 000 000 in 10 periods @ 6%
$10 000 000 x 0.5583948 =
$5 583 948
Actual cash received from the issue
$9,263,991
(which is both the issue price and the PV of the liability)
.
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Illustration (cont.)
Hence, the discount is $736 009. We will assume this
is a direct private placement and hence we will not use
a trust or application account.
1.
.
Dr Cash
Cr Debentures
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9 263 991
9 263 991
10-27
Illustration (cont.)
What does the discount represent?
The discount represents the difference between the face
value of the debentures (in this case $10 000 000) and the
amount actually received from the issue
How should we account for it in subsequent
periods?
The discount is not separately shown. The liability is
disclosed at its present value. In accordance with the
requirements of AASB 139 we use the effective interest
method, which means that at the end of the debenture term
the present value of the debentures will equal the face value
.
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Illustration (cont.)
Using the effective-interest method, the interest expense will equal
the present value of the liability at the beginning of the period
multiplied by the market rate of interest.
9 263 991 x 6%
=
555 839.50
The accounting entries to recognise the payment of interest would
be:
31 December 2012
Dr Interest expense
555 839
Cr Debentures
55 839
Cr Cash
500 000
30 June 2013
Dr Interest expense
559 190
Cr Debentures
59 190
Cr Cash
500 000
.
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Use of the effective-interest method
Worked Example 10.5 (cont.)
Opening
Period liability
0
1
9 263 945
2
9 319 782
3
9 378 969
4
9 441 707
5
9 508 209
6
9 578 702
7
9 653 424
8
9 732 629
9
9 816 587
10
9 905 582
.
Effective
interest
@ 6%
Coupon
rate
555 839.5
559 189.8
562 741.2
566 505.7
570 496.0
574 725.8
579 209.3
583 961.9
588 999.6
594 339.6
500 000
500 000
500 000
500 000
500 000
500 000
500 000
500 000
500 000
500 000
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Net
liability
9 263 991
9 319 830.5
9 379 020.3
9 441 761.5
9 508 267.2
9 578 763.2
9 653 489
9 732 698.3
9 816 660.2
9 905 659.8
10 000 000
10-30
Debentures issued at a premium
Premium
Amount paid for a security in excess of its par/face value
Investors are prepared to pay a premium if:
debentures are issued that provide a coupon rate in excess
of that demanded by the market
the issue price will rise to the point where the effective rate
of return will equal the markets required rate of return
Again, we need to calculate the present value of the
future cash flows discounted at the markets required rate
of return
Refer to Worked Example 10.6 (p. 346)Debentures
issued at a premium
.
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Worked Example 10.6Debentures issued at a
premium
The debenture issue is the same as that in Worked Example 10.5,
except we now assume that the market demands 8% per annum
on such debentures.
Present value of interest payments
$500 000 for 10 periods @ 4%
$500 000 x 8.1108925 =
$4 055 446
Present value of principal repayment
$10 000 000 in 10 periods @ 4%
$10 000 000 x 0.6755643 =
$6 755 643
Actual cash received from the issue
.
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$10 811 089
10-32
Worked Example 10.6Solution (cont.)
Hence a premium of $811 089. We will assume this is
a direct private placement and so we will not use a trust
or application account.
Dr Cash
10 811 089
Cr Debentures
.
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10 811 089
10-33
Worked Example 10.6Solution (cont.)
Again, using the effective-interest method, the interest expense
will equal the present value of the liability at the beginning of the
period multiplied by the market rate of interest.
10 811 089 x 4%
=
432 444
The accounting entries to recognise the payment of interest would
be:
31 December 2012
Dr Interest expense
432 444
Dr debentures
67 556
Cr Cash
500 000
30 June 2013
Dr Interest expense
429 741
Cr Debentures
70 259
Cr Cash
500 000
.
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Hybrid securities
Exhibit characteristics of both debt and equity
More detail on hybrid securities in Chapter 15,
which considers how to account for financial
instruments
Convertible notes:
are debt that allows conversion, at the debt holders
option, into shares of the issuing company
would, if conversion is probable, have an equity
component
would also have a liability component for payment
obligations prior to conversion
.
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Summary
The lecture addresses the general issues pertaining
to liabilities
Liabilities can be classified as current or non-current
How preference shares and convertible notes are
disclosed depends on whether they are of the
substance of debt or equity
For provisions to be liabilities there must be a
present obligation to other entities
Debentures can be issued at par, at a premium or at
a discount and any associated discount or premium
can be accounted for by use of the effective-interest
method or the straight-line method
.
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