Topic 4 - Liabilities: Application Of Financial Reporting Principles

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This article is a topic within the subject Accounting 1B.

Contents

Required Reading

Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 295 & 455-479.

Definition And Recognition Of Liabilities

[1] [2] A Liability is 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. Essential Characteristics are:

  • Present Obligation - A duty or responsibility to act or perform in a certain way.
    • Legally enforceable obligations are caused by a binding contract or statutory requirement.
    • Constructive obligations arise from normal business practice, customs, equitable manner (ethics) or desire to maintain good relations e.g. rectify a product after warranty expiry
    • Difference between present obligation (goods delivered or irrevocable agreement) & future commitments
      • Irrevocable Nature of the Agreement – consequences of failing to honour an obligation will cause an outflow of resources
  • Past Event - Result of past transaction or a past obligating event. E.g. buy G&S (payable), sales & warranty prov.
  • Outflow of Economic Benefits - The settlement of a present obligation involves the entity giving up resources embodying economic benefits E.g. the payment of cash or other assets, provision of services

Recognition occurs if expected future outflows of economic benefits associated with the item are probable & the item has a cost/value that can be measured reliably. (NB estimates don’t undermine reliability)

Obligations under contracts that are equally proportionately underperformed are generally not recognised in financial statements (e.g.no liabilities for inventory not delivered).

Classing Liabilities: Product Warranties

When there are a number of similar obligations (e.g. product warranties) the probability of an outflow being required in settlement is determined by considering the class of obligations as a whole. A single product warranty may only have 5% chance of being needed, but if there are 1000’s its probable that 5% of the total warranties are liabilities.

Measurement of Monetary Liabilities is at present value (PV), discounted at the rate in the contract (equal to face value). Payables are shown net of any discounts. Monetary liabilities are adjusted to reflect any payments to partially discharge the liability

Current And Non Current Liabilities

[3] A liability is classified as current (accruals, accounts payable, notes payable, current tax liabilities & interest bearing) when:

  • It is expected to be settled in the entity’s normal operating cycle
  • Due to be settled within 12 months after the reporting date

Items not expected to be paid within the operating cycle are noncurrent that usually arise from specific financing situations (e.g. borrowings or bonds) or ordinary business operations (e.g. superannuation obligations, deferred tax): provisions

Liabilities are often classified into payables (accounts, accruals, money owed of behalf of others), Interest bearing (notes payable, overdrafts, loans), tax (deferred) & provisions. Current portions of long term debt only include principle repayments for the next 12 months NOT future interest.

Non Current Liabilities: Borrowings & Bonds: Long Term Debt

[4] [5]

Bank Borrowings

Borrowings from banks incorporate time value principles.

  • Recognise Borrowing: DR Cash, CR Borrowings
  • Payment of Interest: DR Interest Expense, CR Interest Payable & :*DR Interest Payable, CR Cash
  • Repayment of Principal: DR Borrowings, CR Cash

Bonds

Bonds are issued by firms & it is a promise to pay interest at set intervals, & to return the investor’s capital on a specified date (a promise to pay something in the future in exchange for receiving something today). It gives firms access to more risk taking investors, in the capital markets, which may be less restrictive & less expensive than a bank.

Bonds are debt instruments that are issued & are generally longer than 1 year. For example, ABC issues 100,000 bonds for $1000 each, with a coupon rate of 5% & maturity in 2 years.

  • Par Value, the principal repaid at maturity - $1000
  • Coupon Rate, the interest rate paid by the issuer - 5%. Coupon Payment, par value × coupon rate=$50, is
  • Fixed Coupon, the interest rate remains fixed over the life of the bond
  • Zero Coupon, no coupon is paid, the bond is initially sold at a discount to par value offering capital gain
  • Floating Rate, the coupon rate is adjusted periodically to account for changes in the market interest rate
  • Maturity Date, the date where par value is to be repaid
  • Yield to Maturity, rate of return earned on a bond held until maturity, required interest rate on the bond in market
  • Market Value, determined by PV of cash flows + risks & considering market interest rates

$1 today is worth more than $1 tomorrow - time value of money. This is because it can earn a return (e.g. by investing).

Bonds are issued at face value, at a discount (Coupon rate < Market rate) or at a premium (Coupon rate > Market rate) to face value due to tax reasons & that the coupon rate is not equal to the market rate of interest.

Further explanation click here.

Accounting Treatment at Face Value

  • Y0: Issuance of Bond: DR Cash 1000, CR Bond Payable 1000
  • Y1 & Y2: Interest Payment: DR Interest Expense 120, CR Cash 120
  • Y2: Repayment of Principal: DR Bond Payable 1000, CR Bond Payable 1000

Accounting Treatment for Discount Bond

  • Y0: Issuance of Bond: DR Cash 966, DR Bond Discount 34, CR Bond Payable 1000
  • Y1: Interest Payment: DR Interest Expense 116, CR Cash 100, CR Bond Discount 16
  • Y1: Interest Payment: DR Interest Expense 118, CR Cash 100, CR Bond Discount 18
  • Y2: Repayment of Principal: DR Bond Payable 1000, CR Bond Payable 1000

Accounting Treatment for Premium Bond

  • Y0: Issuance of Bond: DR Cash 1034, CR Bond Premium 34, CR Bond Payable 1000
  • Y1: Interest Payment: DR Interest Expense 124, DR Bond Premium 16, CR Cash 140,
  • Y1: Interest Payment: DR Interest Expense 122, DR Bond Premium 18, CR Cash 140,
  • Y2: Repayment of Principal: DR Bond Payable 1000, CR Bond Payable 1000

When the proceeds are not the same as what will be repaid, the premium or discount (adjustment to bond payable) must be amortised over the life of the loan. This in effect carries the book value of the bond at the PV of cash flows at the market interest rate of issuance. Contra-accounts are used so the legal debt to be repaid is known.

A Bond Discount is a contra-liability account. It reduces the book value of Bond Payables by an amount that needs to be amortised as an expense (treated as interest) - raises interest expense.

A Bond Premium (contra-liability account) reduces the interest expenses to be paid by amortising a ‘premium’ adjustment to the Bond Payables. The Bond Payable account = Face Value at maturity

Contingent Liabilities & Provisions

[6] Provisions are liabilities that are uncertain in timing or amount & are recognised on the balance sheet. They may be current or noncurrent & may arise due to legal or constructive obligations (e.g. warranties, employee benefits). A provision is recognised when an entity has a present obligation (due to a past event), it is probable that outflows of resources embodying economic benefits will be required to settle the obligation & a reliable estimate can be made. Otherwise a contingent liability will be disclosed in the notes.

  • Creation of Provision - DR Expense, CR Provision
  • Actual Claims Redeemed - DR Provision, CR Cash

Contingent Liabilities are possible obligations arising from past events but whose existence depends on future events or are liabilities that fail the recognition criteria. They are not recognised in the balance sheet but are disclosed in notes (if information is material & possibility of outflows is not remote). (E.g. loan guarantee, possible litigation liabilities, review of tax deductions by ATO)

Other Financing Options

[7]

  • Debt / Hybrid / Equity / Finance Leases
  • OBS – Operating Lease / factoring / LT purchasing commitments / JV’s

End

This is the end of this topic. Click Accounting 1B to go back to the main subject page for Accounting 1B

References

Textbook refers to Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning

  1. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 295
  2. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 456-457
  3. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 458-459
  4. ASB, UNSW
  5. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 464-468
  6. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 468-473
  7. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 473-474
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