1. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–1 Chapter 9 An overview of accounting for liabilities

2. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–2 Learning objectives 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 Continues/ …

3. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–3 Learning 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

4. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–4 Status of newly converged accounting standards AASB 137 ‘Provisions, Contingent Liabilities and Contingent Assets’ replaces AASB 1044 ‘Provisions, Contingent Liabilities and Contingent Assets’ – The two standards are generally equivalent AASB 101 ‘Presentation of Financial Statements’ replaces AASB 1040 ‘Statement of Financial Position’ – The two standards are generally equivalent – AASB 101 provides rules on the disclosure of liabilities Continues/ …

5. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–5 Status of newly converged accounting standards (cont.) The AASB’s ‘Framework for the Preparation and Presentation of Financial Statements’ (the AASB Framework) replaces guidance provided within: – SAC 3 ‘Qualitative Characteristics of Financial Information’; and – SAC 4 ‘Definition and Recognition of the Elements of Financial Statements’ The AASB Framework provides guidance on the definition and recognition of liabilities

6. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–6 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 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 Continues/ …

7. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–7 Liabilities defined (cont.) 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

8. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–8 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 Continues/ …

9. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–9 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 Continues/ …

10. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–10 Contingent liabilities (cont.) It would be inappropriate to recognise them on the balance sheet Disclosure of contingent liabilities is relegated to the notes to the financial reports

11. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–11 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 Continues/ …

12. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–12 Classification of liabilities as ‘current’ or ‘non-current’ (cont.) Current liabilities (AASB 101) are: – 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; or – liabilities in respect of which the entity does not have an unconditional right to defer settlement Non-current liabilities (AASB 101) are: – all liabilities that do not satisfy the criteria for defining current liabilities

13. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–13 Liability provisions Defined as a liability of uncertain timing or amount (AASB 137) 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 Continues/ …

14. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–14 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 Provisions must be reviewed at each reporting date (AASB 137)

15. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–15 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 be influenced by the costs of breaching debt covenants

16. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–16 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 Continues/ …

17. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–17 Debt–equity debate (cont.) AASB 132 ‘Financial Instruments: Disclosure and 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 9.1

18. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–18 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

19. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–19 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 9.2 Continues/ …

20. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–20 Debentures issued at par (cont.) Issue of debentures: DebitCash trust CreditApplication—debentures DebitCash at bank CreditCash trust DebitApplication—debentures CreditDebentures Continues/ …

21. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–21 Debentures issued at par (cont.) Payment of interest: DebitInterest expense CreditCash at bank Redemption of debentures: DebitDebentures CreditCash at bank

22. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–22 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 9.3 Continues/ …

23. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–23 Debentures issued at a discount (cont.) Issue of debentures (assume direct private placement): DebitCash at bank DebitDiscount on debentures CreditDebentures

24. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–24 Amortisation of debenture discount Preferred treatment is for the discount to be recognised as an expense throughout the life of the debentures Two ways to amortise the discount: 1. Straight-line method: discount is divided by the number of interest periods 2. 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) Continues/ …

25. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–25 Amortisation of debenture discount (cont.) Recognise interest (and amortise discount): DebitInterest expense CreditDiscount on debentures CreditCash

26. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–26 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 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 9.4 Continues/ …

27. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–27 Debentures issued at a premium (cont.) Issue of debentures (direct placement): DebitCash at bank CreditDebentures CreditDebenture premium Interest payment: DebitInterest expense DebitDebenture premium CreditCash at bank

28. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–28 Hybrid securities Exhibit characteristics of both debt and equity More detail on hybrid securities in Chapter 14 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 – would, if redemption for cash is probable, be liabilities

29. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–29 Summary The chapter 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

30. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 9–30 Summary of main changes to accounting standards Requirements of AASB 101 and AASB 137 are fundamentally equivalent to the standards they replaced There are some differences, however: – AASB 137 now requires the use of a pre-tax discount rate, reflecting the current market assessments of the time value of money and risks specific to the liability – Where change in carrying amount of a provision is due to the impact of using present values, AASB 137 now requires the change to be recognised as a borrowing cost – The wording of the definition of a liability has changed in the AASB Framework but remains fundamentally the same as that in SAC 4