1. Chapter 9 An overview of accounting for liabilities

2. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-2 Objectives Know the definition of a liability and understand how to apply the recognition criteria provided in the Statement of Concepts. Know the definition of a liability and understand how to apply the recognition criteria provided in the Statement of Concepts. Understand why, with certain transactions, professional judgement is required to determine whether the transaction gives rise to a liability or an item of owners’ equity. Understand why, with certain transactions, professional judgement is required to determine whether the transaction gives rise to a liability or an item of owners’ equity.

3. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-3 Objectives (cont.) 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 some of the reasons why firms would typically prefer to disclose a transaction as part of owners’ equity, rather than as a liability.

4. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-4 Objectives (cont.) Understand how to calculate the issue price of securities, such as debentures. 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. Know how to account for any premium or discount that arises on the issue of debentures. Understand what hybrid securities represent and be able to account for convertible notes. Understand what hybrid securities represent and be able to account for convertible notes.

5. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-5 Objectives (cont.) Understand what a provision represents and be able to apply the recognition criteria to specific provisions. Understand what a provision represents and be able to apply the recognition criteria to specific provisions. Understand what a contingent liability represents and understand how it should be disclosed in the notes to a reporting entity’s financial statements. Understand what a contingent liability represents and understand how it should be disclosed in the notes to a reporting entity’s financial statements.

6. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-6 Objectives (cont.) Know the FRS-15 ‘Accounting for Provisions, Contingent Liabilities and Contingent Assets’ accounting and disclosure requirements. Know the FRS-15 ‘Accounting for Provisions, Contingent Liabilities and Contingent Assets’ accounting and disclosure requirements.

7. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-7 Liabilities defined Liabilities are future sacrifices of service potential or economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events (SC, para. 7.10). Liabilities are future sacrifices of service potential or economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events (SC, para. 7.10).

8. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-8 Three key characteristics There must be a present obligation. There must be a present obligation. There must be adverse financial consequences in that the entity is obliged to sacrifice service potential or future economic benefits to other entities. There must be adverse financial consequences in that the entity is obliged to sacrifice service potential or future economic benefits to other entities. The transaction or other event must have occurred. The transaction or other event must have occurred.

9. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-9 Recognition criteria Must be probable (more likely than less likely) that the sacrifice of economic benefits will be required. Must be probable (more likely than less likely) that the sacrifice of economic benefits will be required. Must be possible to measure the liability reliably. Must be possible to measure the liability reliably. When the above criteria are not satisfied, liabilities may be recorded in notes as contingent liabilities. When the above criteria are not satisfied, liabilities may be recorded in notes as contingent liabilities.

10. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-10 Liabilities classification FRS-9 requires liabilities to be classified and disclosed as current or non-current liabilities. FRS-9 requires liabilities to be classified and disclosed as current or non-current liabilities. Totals of current and non-current liabilities to be included in the statement of financial position. Totals of current and non-current liabilities to be included in the statement of financial position. Current liabilities are expected to be settled within 12 months of the reporting date. Current liabilities are expected to be settled within 12 months of the reporting date.

11. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-11 Contractual implications How liabilities are measured and disclosed will affect contractual arrangements tied in part to liabilities How liabilities are measured and disclosed will affect contractual arrangements tied in part to liabilities –e.g. debt-to-asset constraints. Whether particular accounting methods are adopted will be influenced by costs of breaching debt covenants. Whether particular accounting methods are adopted will be influenced by costs of breaching debt covenants.

12. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-12 Debt/equity debate When faced with the need for additional funds, firms may issue debt-like securities labelled as equity. When faced with the need for additional funds, firms may issue debt-like securities labelled as equity. Debt-like securities include redeemable preference shares, which are redeemable at Debt-like securities include redeemable preference shares, which are redeemable at –the option of the company or the holder; or –on a specified date; or –for a consideration that is specified; or specified; or calculated by reference to a formula; or calculated by reference to a formula; or required to be fixed by a suitably qualified person. required to be fixed by a suitably qualified person.

13. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-13 Implications of debt/equity classification If securities are labelled equity, the associated distributions are termed dividends, which are not an expense but a distribution of surpluses. If securities are labelled equity, the associated distributions are termed dividends, which are not an expense but a distribution of surpluses. If securities are labelled debt, the associated payments are treated as interest (an expense), which leads to a reduction in surpluses. If securities are labelled debt, the associated payments are treated as interest (an expense), which leads to a reduction in surpluses.

14. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-14 Requirements for debt/equity classification Redeemable preference shares that exhibit characteristics of liabilities must be recognised as liabilities in the statement of financial position. Redeemable preference shares that exhibit characteristics of liabilities must be recognised as liabilities in the statement of financial position. Preference shares redeemable at a scheduled redemption date (exhibit characteristics of liabilities) should be differentiated from those redeemable at the option of the issuer. Preference shares redeemable at a scheduled redemption date (exhibit characteristics of liabilities) should be differentiated from those redeemable at the option of the issuer.

15. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-15 Debentures A debenture is a written promise to pay a principal amount at a specified time in the future, as well as interest calculated at a specified rate A debenture is 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 a bond. Debenture liabilities typically secured over the assets of the entity issuing the debenture. Debenture liabilities typically secured over the assets of the entity issuing the debenture. May be issued at par, at premium or at discount. May be issued at par, at premium or at discount.

16. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-16 Debentures issued at par Par (or face) value represents the amount that the debenture holders will receive on maturity of the debentures. Par (or face) value represents the amount that the debenture holders will receive on maturity of the debentures. Investors will pay par if they believe the interest rate offered (coupon rate) accurately reflects what they believe the interest rate should be. Investors will pay par if they believe the interest rate offered (coupon rate) accurately reflects what they believe the interest rate should be.

17. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-17 Journal entries—issue of debenture at par value Issue of debentures: Issue of debentures: DrCash at bank CrDebentures

18. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-18 Journal entries—issue of debenture at par value (cont.) Payment of interest: Payment of interest: DrInterest expense CrCash at bank Redemption of debentures: Redemption of debentures: DrDebentures CrCash at bank

19. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-19 Debentures issued at a discount If the market requires a rate of return in excess of the coupon rate, the issue price must be reduced (discounted) to a price where the cash flows to the investor (periodic interest receipts and the final repayment of principal) represent a rate of return required by the market. If the market requires a rate of return in excess of the coupon rate, the issue price must be reduced (discounted) to a price where the cash flows to the investor (periodic interest receipts and the final repayment of principal) represent a rate of return required by the market.

20. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-20 Accounting for debentures issued at a discount Need to calculate the present value of the future receipts, discounted at the market’s required rate of return. Need to calculate the present value of the future receipts, discounted at the market’s required rate of return. Journal entry to record issue of debentures (assume direct private placement): Journal entry to record issue of debentures (assume direct private placement): DrCash at bank DrDiscount on debentures CrDebentures

21. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-21 Amortisation of debenture discount Preferred treatment is to recognise interest throughout the life of the debentures. Preferred treatment is to recognise interest throughout the life of the debentures. Two ways to amortise the discount: Two ways to amortise the discount: –Straight-line method discount is divided by the number of interest periods. discount is divided by the number of interest periods. –Effective-interest method discount amortisation equals the difference between the present value of the opening liability, multiplied by the market rate of interest, and the actual payment being made (based on the coupon rate). discount amortisation equals the difference between the present value of the opening liability, multiplied by the market rate of interest, and the actual payment being made (based on the coupon rate).

22. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-22 Journal entry to recognise interest (and amortise discount) DrInterest expense CrDiscount on debentures CrCash

23. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-23 Debentures issued at a premium Investors prepared to pay a premium if debentures are issued that provide a coupon rate in excess of that demanded by the market. Investors prepared to pay a premium if debentures are issued that provide a coupon rate in excess of that demanded by the market. Again need to calculate the present value of the future cash flows discounted at the market’s required rate of return. Again need to calculate the present value of the future cash flows discounted at the market’s required rate of return.

24. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-24 Journal entries— debentures issued at a premium Issue of debentures (direct placement): Issue of debentures (direct placement): DrCash at bank CrDebentures CrDebenture premium Interest payment: Interest payment: DrInterest expense DrDebenture premium CrCash at bank

25. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-25 Debentures issued between interest dates Where the debenture is issued between interest dates, the market price equals the PV of the debentures and includes accrued interest to the date of sale. Where the debenture is issued between interest dates, the market price equals the PV of the debentures and includes accrued interest to the date of sale.

26. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-26 Hybrid securities Hybrid securities have both debt and equity characteristics. Hybrid securities have both debt and equity characteristics. More detail in Chapter 14. More detail in Chapter 14. Convertible notes—debt that allows conversion, at the debt-holder’s option, into shares of the issuing company. Convertible notes—debt that allows conversion, at the debt-holder’s option, into shares of the issuing company. When accounting, need to consider likely future outcome. When accounting, need to consider likely future outcome.

27. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-27 Accounting for provisions, contingent liabilities and contingent assets Sufficient information should be disclosed in financial statements so that users are able to understand the nature, timing and amount of provisions, contingent liabilities and contingent assets. Sufficient information should be disclosed in financial statements so that users are able to understand the nature, timing and amount of provisions, contingent liabilities and contingent assets.

28. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-28 Accounting for provisions, contingent liabilities and contingent assets (cont.) A contingency can be distinguished from estimates, trade payables and provisions A contingency can be distinguished from estimates, trade payables and provisions –contingency –estimate –trade payable –provision.

29. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-29 Accounting for provisions A provision is a liability of uncertain timing or amount. A provision is a liability of uncertain timing or amount. They are recognised when all the following conditions are met: They are recognised when all the following conditions are met: –the entity has a present obligation (legal or constructive) as a result of a past event; –it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and –a reliable estimate can be made of the amount of the obligation.

30. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-30 Accounting for provisions (cont.) Elements of the definition: Elements of the definition: –present obligation not limited to legal obligations not limited to legal obligations –past event –probable outflow of resources embodying economic benefits.

31. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-31 Measuring provisions Amount recognised is the best estimate of the expenditure required to settle the present obligation. Amount recognised is the best estimate of the expenditure required to settle the present obligation. Uncertainties surrounding the amount recognised are dealt with using the most likely outcome as well as considering other possible outcomes. Uncertainties surrounding the amount recognised are dealt with using the most likely outcome as well as considering other possible outcomes.

32. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-32 Specific applications Application of general recognition criteria of three specific provisions is detailed in FRS-15: Application of general recognition criteria of three specific provisions is detailed in FRS-15: –future operating losses –onerous contracts –restructuring.

33. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-33 Restructuring Defined as a program that is planned and controlled by management, and materially changes either Defined as a program that is planned and controlled by management, and materially changes either –the scope of the business undertaken by an entity; or –the manner in which that business is conducted. Provision for restructuring costs only recognised when the general recognition criteria for provisions are met. Provision for restructuring costs only recognised when the general recognition criteria for provisions are met.

34. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-34 Calculating a restructuring provision Only direct expenditure arising from a restructuring activity included in the restructuring provision. Only direct expenditure arising from a restructuring activity included in the restructuring provision.

35. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-35 Disclosure of provisions Disclosure requirements contained in FRS-15. Disclosure requirements contained in FRS-15. For each class of provision, disclose: For each class of provision, disclose: –the carrying amount at the beginning and end of the period; –additional provisions made; –amounts used; –unused amounts reversed during the period; and –the increase in the discounted amount arising from the passage of time.

36. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-36 Disclosure of provisions (cont.) For each class of provision, disclose: For each class of provision, disclose: –a brief description of the nature of the obligation; –an indication of the uncertainties about the amount or timing of those outflows; and –the amount of any expected reimbursements.

37. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-37 Contingent liabilities Definition of contingent liability has two components: Definition of contingent liability has two components: –a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or

38. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-38 Contingent liabilities (cont.) a present obligation that arises from past events but is not recognised because: a present obligation that arises from past events but is not recognised 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 reliably.

39. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-39 Recognition of contingent liabilities Contingent liabilities are not recognised. Contingent liabilities are not recognised. They should be disclosed unless the possibility of outflow of resources embodying economic benefits is remote. They should be disclosed unless the possibility of outflow of resources embodying economic benefits is remote. Disclosure takes place in the notes to the financial statements. Disclosure takes place in the notes to the financial statements.

40. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-40 Determining the amount of the contingency Is based on the information available at the time of completion of the financial report. Is based on the information available at the time of completion of the financial report.

41. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-41 Accounting for contingent losses This is determined by the expected outcome of the contingency. This is determined by the expected outcome of the contingency. Where a range of losses is indicated, the best estimate should be accrued and any additional exposure disclosed. Where a range of losses is indicated, the best estimate should be accrued and any additional exposure disclosed.

42. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-42 Accounting for contingent losses (cont.) Where it is probable that the contingency will lead to a loss but there is conflicting or insufficient evidence on which to estimate the amount of the expected loss, the existence and nature of the contingency should be disclosed. Where it is probable that the contingency will lead to a loss but there is conflicting or insufficient evidence on which to estimate the amount of the expected loss, the existence and nature of the contingency should be disclosed. Reimbursements recognised if probable. Reimbursements recognised if probable.

43. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-43 Disclosure of contingent liabilities Disclosures made in the notes to the financial statements. Disclosures made in the notes to the financial statements. The class and description of each contingent liability shuld be disclosed. The class and description of each contingent liability shuld be disclosed. Where practicable, detail Where practicable, detail –an estimate of its financial effect; –an indication of the uncertainties relating to the timing and amount of any outflow; and –the possibility of any reimbursement.

44. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-44 Contingent assets Definition aligned with that of contingent liability. Definition aligned with that of contingent liability. Defined as a possible benefit or claim that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. Defined as a possible benefit or claim that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

45. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-45 Contingent assets definition (cont.) An asset that arises from past events but is not recognised because: An asset that arises from past events but is not recognised because: –it is not probable that the service potential or future economic benefits embodied in the asset will eventuate; or –the asset possesses a cost or other value that cannot be measure reliably.

46. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-46 Contingent asset recognition The recognition of contingent assets is prohibited. The recognition of contingent assets is prohibited. Is is disclosed if it is probable that an inflow of economic benefits will occur. Is is disclosed if it is probable that an inflow of economic benefits will occur. If the realisation is probable, revenue should be recognised. If the realisation is probable, revenue should be recognised.

47. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-47 Disclosure of contingent assets Disclosures should be made in the notes unless the possibility of the inflow of economic benefits is remote. Disclosures should be made in the notes unless the possibility of the inflow of economic benefits is remote. Each class of contingent asset should be disclosed together with a brief description. Each class of contingent asset should be disclosed together with a brief description.

48. Copyright  2003 McGraw-Hill New Zealand Pty Ltd. PPTs t/a New Zealand Financial Accounting 2e by Deegan and Samkin Slides prepared by Grant Samkin 9-48 Disclosure of contingent assets (cont.) Where practicable, provide the following details: Where practicable, provide the following details: –an estimate of its financial effect; –an indication of the uncertainties relating to the amount or timing of any inflow; and –the possibility of any repayment.