Definition: present obligations based on past transactions or events that require either future payment or future performance of services

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1 Liabilities Definition: present obligations based on past transactions or events that require either future payment or future performance of services A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. [IASB Framework, paragraph 4.4 (b)] Liabilities are also captured by IFRS 9: Financial Instruments: A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity [ IAS 32, paragraph 11] Most relevant standards: IFRS 9 (Financial Instruments), IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) 1

2 Liabilities Recognized when incurred; end-of-period adjustments may be necessary classified as current or long-term; determinable or contingent Initial valuation at fair value minus transaction costs that are directly attributable to the issue of the financial liability if classified as measured at amortized costs (IFRS 9, 5.1.1) A liability needs to be classified as either Subsequently measured at amortized costs Or at fair value through profit and loss (Fair value option) Subsequent measurement According to classification Amortized costs: The amount at which the financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between the initial amount and the maturity amount. (IFRS 9, 2 Appendix A)

3 Long-term / current Long-term Liability due beyond the current period or the normal operating cycle, whichever is longer used to cover long-term financing needs Current Liability due within one year or within the normal operating cycle, whichever is longer incurred in connection with operating process long-term liabilities may contain a current portion according to the lapse of time to be shown separately 3

4 Part I: Current Liabilities Accounts Payable sometimes called trade accounts payable balances owed to others for goods and services purchased on open account Short-Term Loans line of credit short-term borrowing when needed Current Maturities of Long-Term Debt portions of long-term debt maturing within the next year are classified as current liabilities e.g. installment due on a long-term liability, i.e. a loan Dividends Payable liability is incurred after the board s decision to pay out dividends liability exists until dividends are paid Subsequent valuation: Current liabilities are valued at the amount due, time value of money is not material Exception: current portion of long term debt 4

5 Unearned Revenues examples: sale of season tickets for a sports club subscription of magazines gift certificates meal tickets accounting treatment when payment is received: debit cash, and credit unearned revenue account when revenue is earned: debit unearned revenue, and credit an earned revenue account Type of Account Title Business Unearned Revenue Earned Revenue Airline Unearned Passenger Ticket Revenue Passenger Revenue Restaurant Unearned Meal Revenue Meal Revenue Magazine Publisher Unearned Subscription Revenue Subscription Revenue Sports Club Unearned Ticket Revenue Ticket Revenue 5 5

6 Economic function of unearned revenue recognize unearned revenue when customers are entitled to receive future service for their present payment with certainty to be distinguished from warranty reserves Example Microsoft unearned revenue increased year after year u.r. arise from sale of Windows and Office you do not buy just the current version but future improvements as well if sales are growing so is unearned revenue Increases in unearned revenues may signal favorable future development! 6

7 Part II: Long-term liabilities -Bonds Some Background information on bonds: securities issued by, e.g. corporations or governmental agencies, to obtain large-sum long-term financing normally due ten to fifty years after issue various covenants and restrictions for protection of both lenders and borrowers small denominations allow collection of large sums of money interest payment annually or semiannually zero bonds bond issue refers to total number of bonds issued at one time 7

8 Why issue bonds? to obtain large sums of money for long time that cannot be collected otherwise e.g. from banks debt financing has some advantages over equity financing stockholder control remains unaffected tax savings: interest expense is tax deductible leverage effect: spread between return on assets and interest cost is usually positive and increases return on equity Stock financing vs. bond financing an example 2 million needed to fund a project alternative I issues shares at current price of 20 per share alternative II issuance of 2 million, 9% bonds at face value 8

9 Funds obtained by... issuance of... issuance of additional shares bonds ( shares ( shares outstanding) outstanding) Earnings before interest and income taxes Interest Earnings before income taxes Income taxes at 35% Net income Earnings per share 1,82 0,47 2,25 0 RoE 9.1% 2.34% 11.27% 0% Note: Net income under bond financing is lower than under stock financing, but return on equity may be higher. Note that interest cost will increase with leverage because of an increasing default risk. Volatility of earning increases. 9

10 How to issue bonds? usually, approval by board of directors and general meeting of shareholders necessary; authorized: number of bonds total face value and nominal interest rate face value: amount of principal the issuer must repay at maturity nominal interest rate determines amount of cash interest the issuer has to pay (also stated rate of interest) bonds are taken by investment banks ( underwriters ) and sold to the public underwriters buy bonds for resale or on a commission basis bondholders are represented by a trustee, typically a large bank contract between company and bank is called bond indenture specifies terms of the bond, rights, privileges, and limitations of bondholders bondholders receive bond certificates as evidence of the company s debt to the bondholder; bondholders are creditors! 10

11 Types of Bonds Secured and Unsecured Bonds secured bonds: bondholders have a claim to certain assets of the company upon default, e.g. mortgage bond unsecured bonds: issued against general credit of borrower (debenture bonds) Term and Serial Bonds term bonds: all bonds of an issue mature on the same date serial bonds: bonds mature over several maturity dates Registered and Coupon Bonds registered bonds: corporation maintains record of all bondholders coupon bonds: bond not recorded in the name of the owner; transferable by delivery cont d next page 11

12 Types of Bonds, cont d Convertible and Callable Bonds convertible bonds: bonds that can be converted into common stock at the option of the holder bonds furnished with a stock option to reduce coupon callable bonds: bonds that can be retired before maturity at the issuer s option Income and Revenue Bonds income bonds: interest payment only if company is profitable revenue bonds: interest on the bonds is paid from specific revenue sources 12

13 Valuation of Bonds Payable bonds are traded in the capital market market rate (effective yield) of interest and (current) bond prices are inversely related yield rate: the virtual interest rate r a bond purchased at the current price in the market yields to the owner Let c denote the coupon, B the bond price, T the maturity (time to repayment), face value = F. Then r is the solution to the following equation: c ( 1 + r) ( + r) The yield for longer term debt uses to be higher than for shorter term debt (normal term structure of interest rates) yield rate (bond price) depend on credit rating F T t + t= 1 1 T = B 13

14 Valuation of Bonds Payable face value stated rate of interest 7% market rate of interest 10% 12% schedule of payments year 1 year 2 year 3 year 4 year 1 year 2 year 3 year 4 interest principal present value of interest present value of principal present value (selling price) of the bond

Inverse relation between interest rates and bond prices B bond #1 stated rate of interest of c 1 = 5% and term to maturity of T 1 = 10 bond #2 - stated rate of interest of c 2 >

15 Inverse relation between interest rates and bond prices B bond #1 stated rate of interest of c 1 = 5% and term to maturity of T 1 = 10 bond #2 - stated rate of interest of c 2 > c 1 and term to maturity of T 2 =T 1 bond #3 - stated rate of interest of c 3 =c 1 and time to maturity T 3 = 5 < T 1 % r assumption: bonds 1-3 have the same face value =

16 Stated rate of interest, market rate of interest, effective rate of interest, and bond issue prices: The stated rate of interest i = c/f may differ from the market rate of interest since the yield must be equal to the market rate the issue price must be adapted accordingly: If the stated rate is lower than the market rate: issue price lower than face value, bond sells at a discount higher than the market rate: issue price exceeds face value, bond sells at a premium at the date of issue must hold with a given market rate r c F T t + t= 1 1 T = ( 1 + r) ( + r) B 16

17 Accounting for bonds payable Bonds are long term financial instruments to be valued at fair value (minus transaction costs) at initial recognition Typically they need to be classified as subsequently measured at amortized costs Definition: Amortized costs: The amount at which the financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between the initial amount and the maturity amount. (IFRS 9, Appendix A) 17

18 Issuing bonds at Face Value ( at par ) stated rate of interest i= rmarket rate of interest accounting entry: cash proceeds = face value of the bonds Example: 5-year term bonds, face value of , dated January 1, 2009, interest rate 8%, annual interest payments on January 1. To record issuance of bonds on January 1 Cash Bonds Payable To record accrued interest expense at year end (December 31) Bond interest expense Bond interest payable

19 Issuing Bonds at Discount stated rate of interest i< rmarket rate of interest Example: as before, but market rate of interest now 10% (stated rate of interest 8%). 5 t= t 1, , discount is has to be amortized over the time to maturity Effective interest rate method has to be applied 5 = 19

20 Issuing Bonds at Discount To record issuance of bonds on January 1 Cash Discount on Bonds Payable Bonds payable To record accrued interest expense and accrued amortization at year-end (December 31) Bond interest expense Discount on Bonds Payable Interest Payable Balance sheet presentation: Long-term liabilities Bonds Payable Less: Discount on Bonds Payable

21 Issuing bonds at a premium stated rate of interest i> rmarket rate of interest Example: as before, but market rate of interest now 6% To record issuance of bonds on January 1 Cash Premium on Bonds Payable Bonds payable To record accrued interest expense and accrued amortization at year-end (December 31) Bond interest expense Premium on Bonds Payable Interest Payable Balance sheet presentation Long-term liabilities Bonds Payable Add: Premium on Bonds Payable

22 Effective interest method The effective interest method is to be applied to amortize discounts and premiums over the lifetime of the bond interest expense = bond carrying value effective rate of interest discount amortization = interest expense interest to be paid premium amortization = interest to be paid interest expense increasing amounts are amortized in each period interest expense is equal to a constant percentage of the carrying value of the bonds interest expense recorded is, thus, increasing under discount and decreasing under premium amortization 22

23 Effective interest discount amortization schedule for an 8% bond sold to yield 10% Annual interest paid interest discount unamortized bond carrying period expense amortization discount value issue date

24 Effective interest premium amortization schedule for 8% bonds sold to yield 6% Annual interest paid interest premium unamortized bond carrying period expense amortization premium value issue date

25 Zero Bonds bonds that bear no interest (explicitly) and are issued solely for cash also called deep discount bonds Example: An 8-year zero bond with face value of 10 million ( x each) is issued and sold at a price of What is the implicit interest rate? = (1 + i) 8 i = = 0,14999 The implicit interest rate is 15%. It is the interest rate that equates (in present value terms) the cash received with the amounts to be paid in the future. 25

26 Disclosure Requirements for Long-Term Debt composition of long-term debt long-term debt maturing within one year should be reported as a current liability maturities of long-term debt during each of the next five years any special arrangements, e.g. refinancing, conversion into stock, off-balance-sheet financing 26

27 Provisions and Contingent Liabilities Provisions: A provision is a liability of uncertain timing or amount (IAS 37, 10) IAS 37 contains general regulations, rules for specific types of provisions are found in several standards E.g. IAS 19 Employee Benefits or IAS 17 Leases A provision should be recognized when, and only when: An entity has a present obligation as a result of a past event (legally or constructive) The obligation needs to involve another party to whom the obligation is owed It is probable (ie more likely than not) that an outflow of resources embodying economic benefits will be required to settle the obligation A reliable estimate can be made of the amount of the obligation. (The standard notes that it is only in extremely rare cases that a reliable estimate will not be possible) 27

28 Provisions and Contingent Liabilities Contingent Liability: a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity or a present obligation that arises from past events but is not recognized because: 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 An entity should not recognize a contingent liability. It should be disclosed in the notes unless the probability of an outflow of resources is remote 28

29 Example Dream Cars Inc., a car dealer, offers various specialties to its customers: Free repair of newly bought cars in case of defect within the next two years Free inspection on request by new customers within the next six months with purchase of 4 new tires before Christmas (as a Christmas customer appreciation special) No definite liability incurred; Uncertain: payee time amount. Nevertheless An obligation as a result of a past event (car sales) is present An outflow of resources is probable, and the amount can reasonably be estimated. Record the estimated amount as a provision! 29

30 Common instances of contingent liabilities: Litigation, claims, and assessments the cause for legal action occurred in the past probability of unfavorable outcome hard to assess estimate of expected loss: legal action is decided but number of claimants uncertain pending litigation vs. actual/possible claims and assessments: no exact amounts disclosed due to influence on position before the court 30

31 Warranty costs Warranty: guarantee to repair or replace defective goods during a predetermined period following the sale Amount and timing is uncertain A provision needs to be recognized: An obligation as a result of a past event (car sales) is present An outflow of resources is probable*, and the amount can reasonably be estimated * If there is a number of similar obligations the probability that an outflow will be required is determined by considering the class of obligations as a whole Matching argument: Cash Basis warranty costs charged to period in which company complies with the warranty Accrual Basis warranty costs charged to period of sale as operating expense 31

32 Example Michael Drums sells music instruments. Per 100 units sold, 2 require warranty service. The cost per service is estimated at 70. In 2002, he sold 800 units. Five warranty services have already been performed at costs totaling 430. Obligation as a result of a past event: sales of music instruments Outflow of resources probable: Prob(at least one unit out of 800 is defect) =1-Prob(zero units are defect) =1- ((800-16)/800) 800 =1-0>0.5 Amount can reasonably be estimated: E(C)=0.02*800* 70= =

33 Journal entries for the example: 1. Sale of 800 units at average price of 100 Cash or Accounts Receivable Sales Recognition of warranty expense Warranty Expense 430 Cash, Inventory, or Accrued Payroll 430 (warranty costs incurred) Warranty Expense 690 Provision for warranty services In 2003 warranty costs of 700 arise related to 2002 sales Provision for warranty expense 690 Warranty expense 10 Cash, Inventory, or Accrued Payroll

34 Environmental liabilities result from obligation to clean up, say, toxic waste or to landscape sites no longer used for business sometimes very hard to estimate the liability indemnity claims after environmental catastrophes For example: Bayer AG [28 ] Other provisions Other provisions are valued in accordance with IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) using the best estimate of the extent of the obligation. Interest-bearing provisions are discounted to present value. Personnel commitments mainly include annual bonus payments, long service awards and other personnel costs. The miscellaneous provisions include 131 million for restructuring. Provisions for environmental protection relate to future relandscaping, landfill modernization and the remediation of land contaminated by past industrial operations. Sufficient provisions have been established for such commitments. [Bayer AG, Annual Report 2000, notes to financial statements.] 34

Chapter 11: Liabilities, on and off balance sheet. General issues Long-term debt, contingent liabilities

Chapter 11: Liabilities, on and off balance sheet General issues Long-term debt, contingent liabilities 1 Liabilities, definition and classification present obligations based on past transactions or events