Chapter 10. An overview of accounting for liabilities. Liabilities defined 3/17/2017. Liabilities defined (cont.)

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1 Chapter 10 An overview of accounting for liabilities 10-1 Liabilities defined A liability is defined 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 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 10-2 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

2 Liabilities defined (cont.) For a liability to be recognised and disclosed in the balance sheet: 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 judgement might be required to determine if a liability should be recognised 10-4 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 It would be inappropriate to recognise them on the statement of financial position Disclosure of contingent liabilities is relegated to the notes to the financial statements 10-5 To summarise Contingent liabilities: obligations only payable contingent (conditional/depending) upon a future event, present obligations not yet probable and/or not measurable reliably (Example: guarantees to cover another organisation s debts or potential obligations from legal actions) or NOT recognised as liabilities in the statement of financial position ONLY disclosure as a note in the notes to the financial statements

3 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 10-7 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 10-8 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

4 Change in the present value of a provision Liabilities, including provisions, shall, to the extent they are payable beyond 12 months, be measured at present value. Let us assume that an organisation in 2019 has a liability for cleaning up a contaminated site in 20 years time at an expected cost of $100 million. The relevant discount rate is 5 per cent. Assuming we don t revise the discount rate or expected cost, the liability in 2019 would be: $100m x = $37.69m The liability one year later would be: $100 m x = $ The entry in 2020 would be: Dr Interest expense 1.88m Cr Provision for clean-up 1.88m To summarise Provisions: Are liabilities of uncertain timing and/or amount that, to the extent they are payable beyond 12 months, shall be measured at present value (AASB 137) They ARE present obligations (to a third party) but: The TIME of the payment is UNCERTAIN and/or the AMOUNT of the payment is UNCERTAIN (Examples: provision for warranty, provision for long service leave) What they are NOT: Amounts provided to cover future expenditure (Examples: provision for future repairs; provision for maintenance)

5 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 Debt equity debate All things being equal, firms typically prefer to disclose low levels of debt If securities are defined as debt : associated payments are treated as interest, therefore occasioning a reduction in profits 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 Refer to Worked Example 10.6 Impact of classifying preference shares as debt, rather than equity

6 Accounting for debentures (bonds) Debentures (bonds) A written promise to pay a principal amount at a specified time in the future, as well as interest calculated at a specified rate Typically secured over the assets of the entity issuing the debenture May be issued at par, at a discount or at a premium 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 10.7 Issue of debentures at par value Debentures issued at par (cont.) Issue of debentures Debit Credit Debit Credit Debit Credit Cash trust Application debentures Cash at bank Cash trust Application debentures Debentures

7 Debentures issued at par (cont.) Payment of interest Debit Credit Interest expense Cash at bank Redemption of debentures Debit Credit Debentures Cash at bank 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 10.8 Debentures issued at a discount Illustration: Debentures issued at a discount Worked Example 10.8 Company C issues $10m, 5 year, 10% semi-annual coupon debentures on 30 June Assume that the market requires 12% for the debentures

8 What would be the issue price? Present value of interest payments $ for 10 6% $ x = $ Present value of principal repayment $ in 10 6% $ x = $ Actual cash received from the issue $9,263,991 (which is both the issue price and the PV of the liability) Illustration (cont.) Hence, the discount is $ 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 Illustration (cont.) What does the discount represent? The discount represents the difference between the face value of the debentures (in this case $ ) 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 9 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

9 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 x 6% = The accounting entries to recognise the payment of interest would be: 31 December 2020 Dr Interest expense Cr Debentures Cr Cash June 2021 Dr Interest expense Cr Debentures Cr Cash Use of the effective-interest method Worked Example 10.8 (cont.) Effective Opening interest Coupon Net Period 6% rate liability 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 10.9 Debentures issued at a premium

10 Worked Example 10.9 Debentures issued at a premium The debenture issue is the same as that in the previous example except we now assume that the market demands 8% per annum on such debentures. Present value of interest payments $ for 10 4% $ x = $ Present value of principal repayment $ in 10 4% $ x = $ Actual cash received from the issue $ Worked Example 10.9 Solution (cont.) Hence a premium of $ We will assume this is a direct private placement and so we will not use a trust or application account. Dr Cash Cr Debentures Worked Example 10.9 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 x 4% = The accounting entries to recognise the payment of interest would be: 31 December 2020 Dr Interest expense Dr debentures Cr Cash June 2021 Dr Interest expense Cr Debentures Cr Cash

11 Hybrid securities Exhibit characteristics of both debt and equity More detail on hybrid securities in Chapter 14, which considers how to account for financial instruments Convertible notes: are debt that allows conversion, at the debtholder 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 Classification of liabilities as current or non-current 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 Classification of liabilities as current or non-current (cont.) 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

12 Set-off of assets and liabilities Set-off reduction of an asset by a liability or of a liability by an asset in the presentation of the statement of financial position the net amount only is presented AASB 132 requires a financial asset and a financial liability to be offset and the net amount presented on the statement of financial position when: a legally enforceable right of set-off exists; and the entity intends either to settle on a net basis or realise the asset and settle the liability simultaneously Set off (cont.) A right of set-off is a right allowing an entity to offset the amount owed to one entity against the amount owed by that of another entity recognised by law or in equity Performing a set-off will improve an entity s gearing ratio, which might be of importance if a firm is subject to constraints imposed by debt agreements, as shown in Worked Example