Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 10-1 Chapter 10 An overview of accounting for liabilities

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 10-2 Objectives of this lecture Know the definition of a liability and understand how to apply the recognition criteria provided in the IASB/AASB Conceptual Framework Understand what a contingent liability represents and understand how it should be disclosed within the notes to a reporting entity’s financial statements Understand that liabilities can be disclosed on a current/non-current basis or in order of liquidity Understand which ‘provisions’ should be treated as liabilities

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 10-3 Objectives (cont.) Understand why, with certain transactions, professional judgment is required to determine whether the transaction gives rise to a liability or should be recognised as part of 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 AASB 9 Financial Instruments The IASB/AASB Conceptual Framework

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 Present obligation Requirements for recognition and disclosure

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 10-6 Contingent liabilities Contingent liabilities defined Examples Recognition Disclosure See Worked Example 10.1, p. 336—Recognition of a contingent liability Figure 10.1 – Contingent Liability Decision Tree (refer to slide 10.7)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 10-7

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 10-8 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 10-9 Liability provisions Defined as a liability of uncertain timing or amount (AASB 137) If amounts are ‘provided’ for future expenditure but there is no obligation to an external party Obligations arising from past events existing independently of an entity’s future actions Measurement of provisions (AASB 137) Reviewing provisions Impact of using present values See Worked Example 10.2, p. 342—Calculating a provision using the expected value method

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Some implications of reporting liabilities Impact on contractual arrangements tied in part to liabilities Managers choice of accounting methods in organisations close to breaching debt covenants Whether or not particular accounting methods are adopted will—it has been hypothesised—be influenced by the costs of breaching debt covenants

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Debt–equity debate Firms typically prefer to disclose low levels of debt Issuing debt-like securities labelled as equity Securities are defined as ‘debt’ AASB 132 Financial Instruments: Presentation Requirement to treat preference shares Refer to Worked Example 10.3, p. 346—Impact of classifying preference shares as debt, rather than equity

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Accounting for debentures (bonds) 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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) matches what they believe the interest rate should be (market rate) Refer to Worked Example 10.4, p. 348—Issue of debentures at par value

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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. 349—Debentures issued at a discount

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Effective-interest method A table can be used to determine the interest expense calculated using the effective-interest method Balance of the debenture liability represents the present value of the liability throughout the debenture term Market’s required rate of return is adopted at the date the debentures were issued as the discount rate Interest expense increases across time as the present value of the liability increases

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Effective-interest method (cont.) Table 10.1 Determining the periodic interest expense under the effective-interest method

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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. 351—Debentures issued at a premium

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Hybrid securities Exhibit characteristics of both debt and equity More detail on hybrid securities in Chapter 14, 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 (bonds) can be issued at par, at a premium or at a discount and interest expense shall be accounted for by use of the effective-interest method in compliance with AASB 9