Chapter 10
An overview of
accounting for liabilities
.
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Objectives of this lecture
• Know the definition of a liability and understand
how to apply the recognition criteria provided in
the AASB’s 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 entity’s 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 AASB’s 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 organisation’s 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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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
entity’s ‘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 entity’s 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 entity’s 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 will—it has been hypothesised—be
influenced by the costs of breaching debt covenants
.
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Debt–equity 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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Debt–equity debate (cont.)
• AASB 132 Financial Instruments: Presentation
– The substance 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
Cash trust
Application—debentures
Debit
Cash at bank
Credit
Debit
Credit
.
Cash trust
Application—debentures
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 market’s 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
discount—Worked 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
9 263 991
9 263 991
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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 market’s required rate of return
• Again, we need to calculate the present value of the
future cash flows discounted at the market’s required rate
of return
• Refer to Worked Example 10.6 (p. 346)—Debentures
issued at a premium
.
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Worked Example 10.6—Debentures 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 10.6—Solution (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
10 811 089
.
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Worked Example 10.6—Solution (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 holder’s
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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