. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-1 Chapter 10 An overview of accounting for liabilities

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-2 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-3 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-4 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)

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-5 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-6 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-7 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-8 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-9 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-10

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Classification of liabilities as current or non- current 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’

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. 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 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 10-15

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Debentures issued at par (cont.) Issue of debentures DebitCash trust CreditApplication—debentures DebitCash at bank CreditCash trust DebitApplication—debentures CreditDebentures

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Debentures issued at par (cont.) Payment of interest DebitInterest expense CreditCash at bank Redemption of debentures DebitDebentures CreditCash at bank

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Debentures issued at a discount (cont.) Issue of debentures (assume direct private placement) DebitCash at bank DebitDiscount on debentures CreditDebentures

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Illustration: Debentures issued at a discount—Worked Example 10.5 Company C issues $10m, 5 year, 10% semi-annual coupon debentures on 30 June Assume that the market requires 12% for the debentures

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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)

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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 2012 Dr Interest expense Cr Debentures Cr Cash June 2013 Dr Interest expense Cr Debentures Cr Cash

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Use of the effective-interest method— Worked Example 10.5 (cont.) Effective Opening interest CouponNet 6%rateliability

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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 $ for 10 4% $ x =$ Present value of principal repayment $ in 10 4% $ x = $ Actual cash received from the issue$

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e Worked Example 10.6—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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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 x 4% = The accounting entries to recognise the payment of interest would be: 31 December 2012 Dr Interest expense Dr debentures Cr Cash June 2013 Dr Interest expense Cr Debentures Cr Cash

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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

. Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 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