1

Liabilities

Definition:• present obligations based on past transactions or events that require

either future payment or future performance of services

• Liabilities are also captured by IFRS 9: Financial Instruments:

−Most relevant standards: IFRS 9 (Financial Instruments), IAS 37 (Provisions, Contingent Liabilities and Contingent Assets)

A liability is a present obligation of the enterprise arising frompast events, the settlement of which is expected to result in anoutflow from the enterprise of resources embodying economicbenefits. [IASB Framework, paragraph 4.4 (b)]

A financial instrument is any contract that gives rise to a financialasset of one entity and a financial liability or equity instrument ofanother entity [ IAS 32, paragraph 11]

2

Liabilities

− Recognized when incurred; end-of-period adjustments may be necessary

− classified as current or long-term; determinable or contingent

• Initial valuation at fair value minus transaction costs that are directly attributable to the issue of the financial liability if classified as measured at amortized costs (IFRS 9, 5.1.1)

• A liability needs to be classified as either– Subsequently measured at amortized costs – Or at fair value through profit and loss (Fair value option)

• Subsequent measurement – According to classification

• Amortized costs: The amount at which the financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between the initial amount and the maturity amount. (IFRS 9, Appendix A)

3

Long-term / current

• Long-term Liability– due beyond the current period or the normal operating cycle, whichever

is longer– used to cover long-term financing needs

• Current Liability– due within one year or within the normal operating cycle, whichever is

longer– incurred in connection with operating process– long-term liabilities may contain a current portion according to the lapse

of time• to be shown separately

4

Part I: Current Liabilities

– Accounts Payable• sometimes called trade accounts payable• balances owed to others for goods and services purchased on open

account– Short-Term Loans

• „line of credit“ – short-term borrowing when needed– Current Maturities of Long-Term Debt

• portions of long-term debt maturing within the next year are classified as current liabilities

• e.g. installment due on a long-term liability, i.e. a loan– Dividends Payable

• liability is incurred after the board‘s decision to pay out dividends• liability exists until dividends are paid

• Subsequent valuation:– Current liabilities are valued at the amount due, time value of money is

not material– Exception: current portion of long term debt

55

Unearned Revenues

• examples:– sale of season tickets for a sports club– subscription of magazines– gift certificates– meal tickets

• accounting treatment– when payment is received: debit cash, and credit unearned revenue

account– when revenue is earned: debit unearned revenue, and credit an earned

revenue account

Type of Account TitleBusiness Unearned Revenue Earned Revenue

Airline Unearned Passenger Ticket Revenue Passenger RevenueRestaurant Unearned Meal Revenue Meal RevenueMagazine Publisher Unearned Subscription Revenue Subscription RevenueSports Club Unearned Ticket Revenue Ticket Revenue

6

Economic function of unearned revenue

• recognize unearned revenue when customers are entitled to receive future service for their present payment with certainty– to be distinguished from warranty reserves

Example – Microsoftunearned revenue increased year after yearu.r. arise from sale of Windows and Office

you do not buy just the current version but future improvements as well

if sales are growing so is unearned revenue

Increases in unearned revenues may signal favorable future development!

7

Part II: Long-term liabilities -Bonds

Some Background information on bonds:

• securities issued by, e.g. corporations or governmental agencies, to obtain large-sum long-term financing

• normally due ten to fifty years after issue• various covenants and restrictions for protection of both lenders and

borrowers• small denominations allow collection of large sums of money• interest payment

– annually or semiannually– zero bonds

• „bond issue“ refers to total number of bonds issued at one time

8

Why issue bonds?

• to obtain large sums of money for long time that cannot be collected otherwise e.g. from banks

• debt financing has some advantages over equity financing– stockholder control remains unaffected– tax savings: interest expense is tax deductible– leverage effect: spread between return on assets and interest cost is

usually positive and increases return on equity• Stock financing vs. bond financing – an example

– € 2 million needed to fund a project– alternative I – issues 100.000 shares at current price of € 20 per share– alternative II – issuance of € 2 million, 9% bonds at face value

9

Funds obtained by ... issuance of ... issuance ofadditional shares bonds(250.000 shares (150.000 shares

outstanding) outstanding)

Earnings before interest and income taxes € 700.000 € 180.000 € 700.000 € 180.000Interest 0 0 180.000 180.000

Earnings before income taxes € 700.000 € 180.000 € 520.000 € 0Income taxes at 35% 245.000 63.000 182.000 0

Net income € 455.000 € 117.000 € 338.000 0

Earnings per share € 1,82 € 0,47 € 2,25 0

Note: Net income under bond financing is lower than under stock financing, but returnon equity may be higher.

Note that interest cost will increase with leverage because of an increasing defaultrisk.

Volatility of earning increases.

RoE 9.1% 2.34% 11.27% 0%

10

How to issue bonds ?

• usually, approval by board of directors and general meeting of shareholders necessary; authorized:– number of bonds– total face value and nominal interest rate

• face value: amount of principal the issuer must repay at maturity• nominal interest rate determines amount of cash interest the issuer

has to pay (also stated rate of interest)– bonds are taken by investment banks („underwriters“) and sold to the

public– underwriters buy bonds for resale or on a commission basis– bondholders are represented by a trustee, typically a large bank– contract between company and bank is called bond indenture

– specifies terms of the bond, rights, privileges, and limitations of bondholders

• bondholders receive bond certificates as evidence of the company‘s debt to the bondholder; bondholders are creditors !

11

Types of Bonds

• Secured and Unsecured Bonds– secured bonds: bondholders have a claim to certain assets of the

company upon default, e.g. mortgage bond– unsecured bonds: issued against general credit of borrower (debenture

bonds)• Term and Serial Bonds

– term bonds: all bonds of an issue mature on the same date– serial bonds: bonds mature over several maturity dates

• Registered and Coupon Bonds– registered bonds: corporation maintains record of all bondholders– coupon bonds: bond not recorded in the name of the owner;

transferable by deliverycont‘d next page

12

Types of Bonds, cont‘d

• Convertible and Callable Bonds– convertible bonds: bonds that can be converted into common stock at

the option of the holder• bonds furnished with a stock option to reduce coupon

– callable bonds: bonds that can be retired before maturity at the issuer‘s option

• Income and Revenue Bonds– income bonds: interest payment only if company is profitable– revenue bonds: interest on the bonds is paid from specific revenue

sources

13

Valuation of Bonds Payable

• bonds are traded in the capital market– market rate (effective yield) of interest and (current) bond prices are

inversely related• yield rate: the virtual interest rate r a bond purchased at the current

price in the market yields to the owner• Let c denote the coupon, B the bond price, T the maturity (time to

repayment), face value = F.• Then r is the solution to the following equation:

• The yield for longer term debt uses to be higher than for shorter term debt (normal term structure of interest rates)

• yield rate (bond price) depend on credit rating

( ) ( )B

rF

rc

T

T

tt =

++⎟⎟

⎠

⎞⎜⎜⎝

⎛

+∑= 111

14

Valuation of Bonds Payable

face value € 300.000 stated rate of interest 7% market rate of interest 10% 12%

schedule of payments year 1 year 2 year 3 year 4 year 1 year 2 year 3 year 4

interest € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000 € 21.000principal € 300.000 € 300.000

present value of interest € 66.567 € 63.784present value of principal € 204.904 € 190.655

present value (selling price) of the bond € 271.471 € 254.440

15

Inverse relation between interest rates and bond prices

bond #1 – statedrate of interest of c1= 5% and term tomaturity of T1= 10

bond #2 - statedrate of interest ofc2 > c1 and term tomaturity of T2=T1

bond #3 - statedrate of interest ofc3=c1 and time tomaturity T3 = 5 < T1

assumption: bonds 1-3 have the same face value = 100

% r

B

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Stated rate of interest, market rate of interest, effective rate of interest, and bond issue prices:

• The stated rate of interest i = c/F may differ from the market rate of interest– since the yield must be equal to the market rate the issue price must be

adapted accordingly:• If the stated rate is

– lower than the market rate: issue price lower than face value, bond sells at a discount

– higher than the market rate: issue price exceeds face value, bond sells at a premium

• at the date of issue

must hold with a given market rate r

( ) ( )B

rF

rc

T

T

tt =

++⎟⎟

⎠

⎞⎜⎜⎝

⎛

+∑= 111

17

Accounting for bonds payable

• Bonds are long term financial instruments to be valued at – fair value (minus transaction costs) at initial recognition– Typically they need to be classified as subsequently measured

at amortized costs

Definition:• Amortized costs: The amount at which the financial liability is

measured at initial recognition minus the principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between the initial amount and the maturity amount. (IFRS 9, Appendix A)

18

Issuing bonds at Face Value (“at par”)

• stated rate of interest i = r market rate of interest• accounting entry: cash proceeds = face value of the bonds

– Example: 5-year term bonds, face value of € 900.000, dated January 1, 2009, interest rate 8%, annual interest payments on January 1.

To record issuance of bonds on January 1

Cash 900.000

Bonds Payable 900.000

To record accrued interest expense at year end (December 31)

Bond interest expense 72.000

Bond interest payable 72.000

19

Issuing Bonds at Discount

• stated rate of interest i < r market rate of interest– Example: as before, but market rate of interest now 10% (stated rate of

interest 8%).

– discount is 68.234– has to be amortized over the time to maturity– Effective interest rate method has to be applied

766.8311,1000.900

1,1000.72

5

5

1=+∑

=tt

2020

Issuing Bonds at Discount

Long-term liabilities Bonds Payable € 900.000 Less: Discount on Bonds Payable 112.159 € 787.841

Balance sheet presentation:€ 900 000

68.234 € 831.766

To record issuance of bonds on January 1

Cash 831.766

Discount on Bonds Payable 68.234

Bonds payable 900.000

To record accrued interest expense and accrued amortization at year-end (December 31)

Bond interest expense 83.177

Discount on Bonds Payable 11.177

Interest Payable 72.000

2121

Long-term liabilities Bonds Payable € 900.000 Add: Premium on Bonds Payable 133.901 € 1.033.901

Balance sheet presentation

Issuing bonds at a premium

• stated rate of interest i > r market rate of interest– Example: as before, but market rate of interest now 6%

€ 900 00075.823 € 975.823

To record issuance of bonds on January 1

Cash 975.823

Premium on Bonds Payable 75.823

Bonds payable 900.000

To record accrued interest expense and accrued amortization at year-end (December 31)

Bond interest expense 58.549

Premium on Bonds Payable 13.451

Interest Payable 72.000

22

Effective interest method

• The effective interest method is to be applied to amortize discounts and premiums over the lifetime of the bond

• interest expense = bond carrying value × effective rate of interest– discount amortization = interest expense – interest to be paid– premium amortization = interest to be paid – interest expense

– increasing amounts are amortized in each period• interest expense is equal to a constant percentage of the

carrying value of the bonds• interest expense recorded is, thus, increasing under discount

and decreasing under premium amortization

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Annual interest paid interest discount unamortized bond carryingperiod expense amortization discount value

issue date 68.234 831.7661 72.000 83.177 11.177 57.057 842.9432 72.000 84.294 12.294 44.763 855.2373 72.000 85.524 13.524 31.239 868.7614 72.000 86.876 14.876 16.363 883.6375 72.000 88.364 16.364 0 900.000

Effective interest discount amortization schedule for an 8% bond sold to yield 10%

24

Effective interest premium amortization schedule for 8% bonds sold to yield 6%

Annual interest paid interest premium unamortized bond carryingperiod expense amortization premium value

issue date 75.823 975.8231 72.000 58.549 13.451 62.372 962.3722 72.000 57.742 14.258 48.115 948.1153 72.000 56.887 15.113 33.002 933.0024 72.000 55.980 16.020 16.982 916.9825 72.000 55.019 16.981 1 900.001

25

Zero Bonds

• bonds that bear no interest (explicitly) and are issued solely for cash• also called deep discount bonds

– Example: An 8-year zero bond with face value of € 10 million (10.000 x € 1.000 each) is issued and sold at a price of € 3.270.000.

• What is the implicit interest rate ?

• The implicit interest rate is 15%. It is the interest rate that equates (in present value terms) the cash received with the amounts to be paid in the future.

8)1(000.000.10€000.270.3€ −+⋅= i

14999,01000.270.3000.000.10

8 =−=i

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Disclosure Requirements for Long-Term Debt

• composition of long-term debt• long-term debt maturing within one year should be reported as a

current liability• maturities of long-term debt during each of the next five years• any special arrangements, e.g. refinancing, conversion into stock,

„off-balance-sheet financing“

27

Provisions and Contingent Liabilities

• Provisions:– A provision is a liability of uncertain timing or amount (IAS 37, 10)– IAS 37 contains general regulations, rules for specific types of

provisions are found in several standards• E.g. IAS 19 Employee Benefits or IAS 17 Leases

• A provision should be recognized when, and only when:– An entity has a present obligation as a result of a past event (legally or

constructive)• The obligation needs to involve another party to whom the

obligation is owed– It is probable (ie more likely than not) that an outflow of resources

embodying economic benefits will be required to settle the obligation– A reliable estimate can be made of the amount of the obligation.

(The standard notes that it is only in extremely rare cases that a reliable estimate will not be possible)

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Provisions and Contingent Liabilities

• Contingent Liability:• 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 a present obligation that arises from past events but is not recognized 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 with sufficient

reliability• An entity should not recognize a contingent liability. It should be

disclosed in the notes unless the probability of an outflow of resources is remote

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Example

• Dream Cars Inc., a car dealer, offers various specialties to its customers:– Free repair of newly bought cars in case of defect within the next two

years– Free inspection on request by new customers within the next six months

with purchase of 4 new tires before Christmas (as a Christmas customer appreciation special)

• No definite liability incurred; Uncertain:– payee – time– amount.

• Nevertheless– An obligation as a result of a past event (car sales) is present– An outflow of resources is probable, and– the amount can reasonably be estimated.

Record the estimated amount as a provision!

30

Common instances of contingent liabilities:

• Litigation, claims, and assessments– the cause for legal action occurred in the past– probability of unfavorable outcome hard to assess– estimate of expected loss: legal action is decided but number of

claimants uncertain– pending litigation vs. actual/possible claims and assessments: no exact

amounts disclosed due to influence on position before the court

31

Warranty costs

• Warranty: guarantee to repair or replace defective goods during a predetermined period following the sale– Amount and timing is uncertain

• A provision needs to be recognized:– An obligation as a result of a past event (car sales) is present– An outflow of resources is probable*, and– the amount can reasonably be estimated

* If there is a number of similar obligations the probability that an outflow will be required is determined by considering the class of obligations as a whole

• Matching argument:– Cash Basis – warranty costs charged to period in which

company complies with the warranty– Accrual Basis – warranty costs charged to period of sale as

operating expense

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Example

• Michael Drums sells music instruments. Per 100 units sold, 2 require warranty service. The cost per service is estimated at € 70. In 2002, he sold 800 units. Five warranty services have already been performed at costs totaling € 430.

– Obligation as a result of a past event: sales of music instruments

– Outflow of resources probable:Prob(at least one unit out of 800 is defect) =1-Prob(zero units are defect) =1- ((800-16)/800)800=1-0>0.5

– Amount can reasonably be estimated:E(C)=0.02*800*€70= €1.120 €1.120-€430= € 690

33

Journal entries for the example:

1. Sale of 800 units at average price of € 100

Cash or Accounts Receivable 80.000Sales 80.000

2. Recognition of warranty expense

Warranty Expense 430Cash, Inventory, or Accrued Payroll 430(warranty costs incurred)

Warranty Expense 690Provision for warranty services 690

3. In 2003 warranty costs of 700 arise related to 2002 sales

Provision for warranty expense 690Warranty expense 10

Cash, Inventory, or Accrued Payroll 700

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Environmental liabilities

• result from obligation to clean up, say, toxic waste or to landscape sites no longer used for business– sometimes very hard to estimate the liability– indemnity claims after environmental catastrophes

• For example: Bayer AG“[28 ] Other provisionsOther provisions are valued in accordance with IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) using the best estimate of the extent of the obligation. Interest-bearing provisions are discounted to present value. Personnel commitments mainly include annual bonus payments, long service awards and other personnel costs. The miscellaneous provisions include € 131 million for restructuring. Provisions for environmental protection relate to future relandscaping, landfill modernization and the remediation of land contaminated by past industrial operations. Sufficient provisions have been established for such commitments.” [Bayer AG, Annual Report 2000, notes to financial statements.]