1. Powerpoint slides by: Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Michael L. Hockenstein  Commerce Department Vanier College Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management Dalhousie University

2. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-2 Liabilities Chapter 13

3. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-3 What is a Liability?  A liability is defined in the CICA Handbook as having three essential characteristics: it embodies a duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other yielding of economic benefits, at a specified or determinable date, on occurrence of a specified event, or on demand the duty or responsibility obligates the entity, leaving it little or no discretion to avoid it the transaction or event obligating the entity has already occurred

4. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-4 What is a Liability? (cont.)  These characteristics can be simplified for practical purposes by remembering that a liability is: a highly probable future sacrifice of assets or services constituting a present obligation that is the result of a past transaction or event

5. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-5 What is a Liability? (cont.)  Contractual obligation : a commitment that will become a liability in the future, once an event has occurred  Contractual obligations are often called executory contracts  If they are large and unusual, they may be reported in the notes to the financial statements

6. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-6 What is a Liability? (cont.)  Matching of revenue and expense leads to the recognition of liabilities as an offset to expenses that are matched to revenue in a period, even though there is no present obligation to any specific individual or organization, e.g., accrual of the estimated costs of fulfilling warranties in the future for goods sold in the current period

7. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-7 What is a Liability? (cont.) an estimate of the liability under special coupon or other promotional activities carried out in the current period (e.g., frequent flier points for an airline) an annual provision for major maintenance costs that are incurred regularly, but not every year (e.g., the cost of relining furnaces in a steel mill that is done every few years) a liability for environmental clean-up costs by a resource company, even if it is under no legal requirement (at the time of reporting) to incur such costs

8. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-8 Contingent Liabilities vs. Estimated Liabilities  Contingent liability: is a potential liability that will become a real liability only if and when another event happens  Contingent liabilities should be distinguished from estimated liabilities  Estimated liabilities: those that are known to exist, but for which the exact amount is unknown

9. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-9 Contingent Liabilities vs. Estimated Liabilities (cont.)  CICA Handbook states: In the preparation of the financial statements of an enterprise, estimates are required for many on-going and recurring activities. However, the mere fact that an estimate is involved does not of itself constitute the type of uncertainty which characterizes a contingency [CICA 3290.04]

10. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-10 Examples of Contingent Liabilities  Examples of contingent liabilities are as follows: a company is guarantor on loans extended to others, such as to subsidiaries, parent companies, other related companies (e.g., under common ownership), or owners; if the primary borrower defaults, the company becomes liable a company has received a government loan that will be forgiven, if the company maintains certain employment levels and/or makes specified investments; if the conditions are not met, the loan must be repaid

11. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-11 Reporting Contingent Liabilities  An enterprise has the following three possibilities for reporting contingent liabilities: accrue the estimated cost as a liability in the balance sheet and as a loss on the income statement disclose the contingency and the possible liability in the notes to the financial statements neither accrue the contingency in the financial statements nor disclose it in the notes

12. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-12 Reporting Contingent Liabilities  The accounting treatment depends on two characteristics of the contingency: the likelihood of the contingency occurring the measurability of the resulting liability or loss

13. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-13 Reporting Contingent Liabilities (cont.)  A contingent loss is accrued when the occurrence of the loss is likely, and the amount can be measured  A contingent loss is disclosed when the occurrence of the loss is likely, but the amount cannot be measured the occurrence of the loss is likely, and the amounts can be measured and have been recorded, but there is some chance that the amount recorded is not high enough

14. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-14 Reporting Contingent Liabilities (cont.) the likelihood of the loss event can’t be determined, regardless of whether the amount can be measured the occurrence of the loss is unlikely, but the amounts involved are material; in other words, the event would have a significant adverse effect on the company

15. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-15 Valuation of Liabilities  The basic principle of liability valuation is that monetary liabilities should be reported at their present value at issuance, adjusted for amortization  Present value is calculated using the borrower’s interest rate for debts of similar term and risk

16. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-16 Current Liabilities  A current liability: one that is due or payable within the next operating cycle or the next fiscal year, whichever period is longer  Current liabilities normally are listed by descending order to the strength of the creditors’ claims

17. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-17 Current Liabilities (cont.)  Bank debt and promissory notes are listed first, and estimated liabilities and deferred credits are listed last  A common sequence is: bank loans other notes payable current portion of long-term liabilities trade accounts payable other payables accrued liabilities unearned revenues miscellaneous deferred credits

18. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-18 Sources of Short-Term Financing  Trade credit extended by suppliers is a source of “interest-free” financing  Signing promissory notes that obligate the company to pay the supplier (or an intermediary, such as a bank) at or before a given date  Operating lines of credit are secured by a lien or charge on accounts receivable and/or inventory, due on demand  Large corporations are companies with good credit ratings that can issue commercial paper

19. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-19 Sources of Short-Term Financing (cont.)  Assignment: company promises that the proceeds of its accounts and/or notes receivable will be assigned to the finance company  Sale: company sells its accounts and/or notes receivable to a finance company at a discounted value and all payments are collected by the finance company

20. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-20 Long-Term Liabilities  A long-term liability: a liability with repayment terms extending beyond one year from the current balance sheet date or the operating cycle of the borrower, whichever is longer  Long-term debt is often an attractive means of financing for the debtor creditors do not acquire voting privileges in the debtor company, and issuance of debt causes no ownership dilution

21. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-21 Long-Term Liabilities (cont.) debt capital is obtained more easily than equity capital for many companies, especially private companies interest expense, unlike dividends, is tax deductible a firm that earns a return on borrowed funds that exceeds the rate it must pay in interest is using debt to its advantage and is said to be successfully levered (or leveraged)

22. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-22 Long-Term Liabilities (cont.)  Debt is an attractive investment for creditors because it provides: legally enforceable debt payments eventual return of principal a prior claim to assets if the corporation restructures its debt or if it goes into receivership or bankruptcy

23. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-23 Long-Term Liabilities (cont.)  Long-term debt can take a wide variety of forms, including: bank loans notes payable mortgages other asset-based loans publicly-issued bonds, secured or unsecured long-term leases

24. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-24 Bank Financing  For accounting purposes, any loan that is not current is long-term  From a banks’ point of view, non-current loans can be identified as term loans and commercial mortgages  Term loans : debt financial instruments with a usual term of one to five years term loans may be secured by charges on specific assets including land, building, and other capital assets

25. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-25 Bank Financing (cont.)  The repayment terms of medium-term loans can be structured in either of two ways: blended payments---the interest rate is fixed at the beginning of the loan term, and regular equal annuity payments are made that include both principal and interest designated monthly principal payments, plus accrued interest on the outstanding balance--- the interest rate may be fixed at the beginning of the loan term, or may float with prime interest rates

26. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-26 Bank Financing (cont.)  Long-term loans, in the eyes of the banks, are loans with repayment terms extending beyond five years  The banks typically grant such loans as asset - based financing or as commercial mortgages  Commercial mortgages are secured against land and buildings, and involve regular blended payments (e.g., monthly or semi-monthly) years, and may be shorter

27. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-27 Bank Financing (cont.)  The amortization period of such loans could be for as long as 25 years, but the term, or the bank’s commitment to extending the loan, is usually a shorter period  The term normally will not exceed five years  When a long-term loan is extended at a fixed interest rate, the interest rate is fixed only for the term of the loan, not for the entire amortization period

28. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-28 Bonds  A bond : a debt security issued by corporations and governments to secure large amounts of capital on a long-term basis  A bond represents a formal promise by the issuing organization to pay principal and interest in return for the capital invested  A formal bond agreement, known as a bond indenture, specifies: the terms of the bonds the rights and duties of both the issuer and the bondholder

29. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-29 Bonds (cont.)  The bond indenture specifies: any restrictions on the issuing company the dollar amount authorized for issuance the interest rate payment dates maturity date any conversion and call privileges

30. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-30 Exhibit 13-1

31. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-31 Exhibit 13-1

32. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-32 Other Sources of Long-Term Debt  For small and most medium-sized private companies, the chartered banks are the major source of financing  Larger corporations can arrange loans with life insurance companies or pension funds, which have money to invest for long periods of time  Leasing companies are another source of asset- backed lending

33. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-33 Debt Covenants  Debt agreements often restrict the operations and financial structure of the borrower to reduce the risk of default  Covenants : restrictions placed on a corporation’s activities as a condition of maintaining the loan  If the covenants are broken, the lender has the right to call the loan; the lender can demand immediate repayment of the principal  Bankers also refer to covenants as maintenance tests

34. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-34 Debt Covenants (cont.)  Restrictions can be either accounting- based or behavioural  Accounting-based covenants: maximum debt:equity ratio minimum interest coverage ratio minimum inventory turnover (i.e., the relationship between cost of goods sold and inventory) restrictions on dividend payout

35. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-35 Debt Covenants (cont.)  Restricted actions: limitations on the issuance of additional debt without the permission of the lender restrictions on dividend payments prohibition or restriction on the redemption or retirement of shares of the company to pledge assets as security for other purposes requirement that current management or key employees remain in place limitations on a transfer of control

36. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-36 Sinking Funds  A debt agreement may require that the company establish a sinking fund  A sinking fund : a cash fund restricted for retiring the debt  Each year, the company pays into the sinking fund  The sinking fund may be trusteed, in which case the fund is handled by the trustee and the company has no access to the funds

37. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-37 Sinking Funds (cont.)  The trustee is responsible for investing the fund in appropriate investments that often includes the purchase of the company’s bonds in the open market  Repurchase of the bonds to which the sinking fund is linked has the effect of reducing the outstanding debt, and companies often offset such holdings against the outstanding bonds, so that the balance sheet only shows the amount of bonds outstanding

38. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-38 Effective Versus Nominal Interest Rates  The nominal interest rate : the interest rate stated in the loan agreement  The effective interest rate, or yield : the true cost of borrowing; the rate that equates the price of the liability to the present value of the interest payments plus the maturity value based on compounding periods  Financial markets express interest rates at nominal amounts  The lender will quote the nominal interest rate and the compounding period, and expect the borrower to understand that the effective rate is higher

39. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-39 Notes Payable  Accounting for long-term debt is simple if the effective interest rate and the nominal interest rate are the same  Nominal rate = effective rate  PV of the future cash flows, discounted at the effective interest rate, will equal the face value of the debt  Interest is accrued as time passes, and principal and interest payments are accounted for as cash is disbursed

40. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-40 Notes Payable (cont.)  Nominal interest rate is materially different from the market interest rate at the time the note is issued  Present value techniques are used for the valuation of the note, and accounting for the periodic interest expense  Amortization of discount (or premium) can be by either of two methods: the effective interest method straight-line method

41. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-41 Balance Sheet Classification  On a classified balance sheet, long-term loans are classified as long-term liabilities  The portion of principal that is due within the next year (or operating cycle) is classified as a current liability  Any accrued interest at the balance sheet date is also classified as a current liability

42. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-42 Balance Sheet Classification (cont.)  The usual practice is to disclose the total amount of any outstanding long-term bonds or loan, and then to show the reclassification of the amount due within the next year as a current liability  This disclosure can be either in the notes to the financial statements or shown on the face of the balance sheet

43. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-43 Bond Issue Costs  Bond issue costs include legal, accounting, underwriting, commission, engraving, printing, registration, and promotion costs  These costs are paid by the issuer and reduce the net proceeds from the bond issue, increasing the effective cost for the issuer

44. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-44 Bond Issue Costs (cont.)  There are two methods that may be used in accounting for bond issue costs: deduct the issue costs from the net proceeds of the bonds, and thereby include them in the bond premium or discount account for the issue costs separately, as a deferred charge that is amortized over the life of the bond issue  Under either method, bond issue costs are amortized over the bond term

45. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-45 Up-Front Fees  Lenders frequently charge an up-front fee when granting a loan  These are called administrative fees  For example, assume that a firm borrows $100,000 for two years, and agrees to pay 7%, with interest paid annually. In addition, the bank charges the firm an administrative fee of $3,520 on the day the loan is granted. The lender will advance the borrower the net proceeds, or $96,480 ($100,000  $3,520), at the inception of the loan

46. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-46 Up-Front Fees (cont.)  For many years, accounting practice allowed the lender and borrower to take this fee onto the income statement in the period of payment, which resulted in fee revenue for the bank and financing expense for the borrower  However, accountants often argue that this up- front fee is part of the cost of borrowing over the life of the loan, and should be treated accordingly

47. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-47 Debt Retirement  Bonds retired at maturity are recorded by reducing the liability and the asset given in repayment; no gain or loss arises  Bonds retired before maturity through call redemption, or open market purchase, typically involve recognition of a gain or loss as the difference between the book value of the debt and the consideration paid

48. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-48 Defeasance  Extinguishment of debt may be accomplished by defeasance, which requires a company to place assets in an irrevocable trust sufficient to pay the debt interest and principal  Defeasance is recorded with an entry that removes the assets, liability, and related accounts, and records a gain

49. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-49 In-Substance Defeasance  In-substance defeasance is similar to defeasance, except that the trust is not irrevocable  Recent recommendations discourage removing in-substance defeased debt obligations from the balance sheets

50. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-50 Foreign Exchange Considerations  Many Canadian companies borrow from foreign lenders  The most common source of non-Canadian financing is the U.S., both through U.S. banks and other financial institutions and, for large public companies, through the bond markets  The most obvious point of these loans is that they may subject the borrowing company to the additional risk of foreign exchange

51. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-51 Accounting For Foreign Currency- Denominated Debt--Unhedged Debt  The basic principle underlying balance sheet reporting of foreign currency monetary liabilities is that they should be reported in the balance sheet in the equivalent amount of reporting currency (normally, Canadian dollars for Canadian companies) at the spot rate on the balance sheet date  The loan principal is translated into Canadian dollars on the day it is borrowed at the current, or spot, exchange rate  At every subsequent reporting date, the loan is re- measured at the spot rate

52. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-52 Accounting For Foreign Currency- Denominated Debt---Unhedged Debt (cont.)  If exchange rates have changed, an exchange gain or loss will result  Under current Canadian rules, the exchange gain or loss on a long-term loan is treated as follows: for short-term liabilities, the gain or loss is taken into income in the current period for long-term liabilities, the gain or loss is deferred and amortized over the remaining period until maturity

53. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-53 Hedged Debt  If the loan is hedged, then the entity is not exposed to unpredictable exchange gains or losses  Since the presence of a hedge significantly reduces the risk associated with debt that is not denominated in Canadian dollars, it is important to disclose the existence of a hedge in the notes to the financial statements

54. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-54 Disclosures for Long-Term Liabilities  The required disclosures for long-term debt are outlined in the CICA Handbook, Section 3210, “Long-term Debt” and Section 3860, “Financial Instruments  Disclosure and Presentation”  The long term debt section recommends the following information be disclosed: for debentures and similar securities, the title of the issue, interest rate, maturity date, amount outstanding, sinking fund, if any, and redemption or conversion privileges for mortgages and other long-term debt, the same details to the extent practical

55. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-55 Disclosures for Long-Term Liabilities (cont.) the aggregate amount of payments required in the next five years to meet sinking fund or retirement provisions if the debt is denominated in a foreign currency, then the currency in which the debt is to be repaid must be disclosed secured liabilities must be shown separately, and the fact that they are secured details of any defaults of the company in principal, interest, sinking fund or redemption provisions interest expense on long-term debt, separately on the income statement

56. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   13-56 Disclosures For Long-Term Liabilities (cont.)  Section 3860 outlines the disclosure requirements for financial instruments, a generic term that includes long-term liabilities  these requirements supplement those of Section 3210, and require disclosure in the following areas : terms and conditions interest rate risk fair value