Deegan Chapter 10

Chapter 10
An overview of accounting
for liabilities
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Deegan, Financial Accounting, 8e 10-1
Objectives of this lecture

• Know the definition of a liability and understand
how to apply the recognition criteria provided in
the 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 which ‘provisions’ should be treated
as liabilities

Objectives (cont.)
• Understand why, with certain transactions,
professional judgement 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

Liabilities defined
• A liability is defined 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

Liabilities defined (cont.)
• As we can see from the definition, a central aspect
of a ‘liability’ is the existence of a ‘present obligation’
• 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

Liabilities defined (cont.)

• For a liability to be recognised and disclosed in the balance
sheet:
– 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 judgement might be required to determine if

a liability should be recognised

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
• It would be inappropriate to recognise them on the
statement of financial position
• Disclosure of contingent liabilities is relegated to the
notes to the financial statements

To summarise—Contingent liabilities:
 obligations only payable contingent (conditional/depending)
upon a future event,
or
 present obligations not yet probable and/or not measurable

reliably
(Example: guarantees to cover another organisation’s debts or

potential obligations from legal actions)
• NOT recognised as liabilities in the statement of financial position
• ONLY disclosure as a note in the notes to the financial statements

Liability provisions
• Defined as a liability of uncertain timing or amount (AASB 137)
• Therefore if something is disclosed as a provision this should

alert the reader to the uncertainties inherent in its ultimate
payment
• 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

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

Liability provisions (cont.)
• Provisions must be reviewed at each reporting date (AASB 137)
• Where a change in the carrying amount of a provision is due to

the impact of using present values, AASB 137 requires the
change to be recognised as a ‘borrowing cost’, specifically
paragraph 60 states:
– where discounting is used, the carrying amount of a provision

increases in each period to reflect the passing of time. This
increase is recognised as a borrowing cost

Change in the present value of a provision
• Liabilities, including provisions, shall, to the extent they are

payable beyond 12 months, be measured at present value.
• Let us assume that an organisation in 2019 has a liability for

cleaning up a contaminated site in 20 years time at an expected
cost of $100 million. The relevant discount rate is 5 per cent.
Assuming we don’t revise the discount rate or expected cost,
the liability in 2019 would be: $100m x 0.3769 = $37.69m
• The liability one year later would be: $100 m x 0.3957 = $39.57.
The entry in 2020 would be:
Dr Interest expense 1.88m
Cr Provision for clean-up 1.88m

To summarise—Provisions:
Are liabilities of uncertain timing and/or amount that, to
the extent they are payable beyond 12 months, shall be
measured at present value (AASB 137)
• They ARE present obligations (to a third party) but:

The TIME of the payment is UNCERTAIN
and/or
the AMOUNT of the payment is UNCERTAIN
• (Examples: provision for warranty, provision for long service
leave)
What they are NOT:

Amounts ‘provided’ to cover future expenditure
(Examples: provision for future repairs; provision for
maintenance)

Provisions vs contingent liabilities
• Appendix B to AASB 137 provides a useful decision

tree for determining whether a transaction or event
should be recognised as a provision and therefore
included within the statement of financial position, or
disclosed as a contingent liability within the notes to
the financial statements.
• The decision tree is reproduced on the following slide

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—it has been hypothesised—be influenced by the costs of
breaching debt covenants

Debt–equity debate
• All things being equal, firms typically prefer to disclose

low levels of debt
• If securities are defined as ‘debt’:

– associated payments are treated as interest,
therefore occasioning a reduction in profits

Debt–equity debate (cont.)
• AASB 132 Financial Instruments: 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
• Refer to Worked Example 10.6—Impact of classifying

preference shares as debt, rather than equity

Accounting for debentures (bonds)
• Debentures (bonds)
– A written promise to pay a principal amount at a
specified time in the future, as well as interest
calculated at a specified rate
– Typically secured over the assets of the entity issuing
the debenture
– May be issued at par, at a discount or at a premium

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 10.7—Issue of debentures at
par value

Debentures issued at par (cont.)
• Issue of debentures
Debit Cash trust

Credit Application—debentures
Debit Cash at bank
Credit Cash trust
Debit Application—debentures
Credit Debentures

Debentures issued at par (cont.)

• Payment of interest
Debit Interest expense

Credit Cash at bank
• Redemption of debentures
Debit Debentures
Credit Cash at bank

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 10.8—Debentures issued at a
discount

Illustration: Debentures issued at a

discount—Worked Example 10.8
Company C issues $10m, 5 year, 10% semi-annual

coupon debentures on 30 June 2020. Assume that the
market requires 12% for the debentures

What would be the issue price?
Present value of interest payments

$500,000 for 10 periods @ 6%
$500,000 x 7.3600866 = $3,680,043
Present value of principal repayment

$10,000,000 in 10 periods @ 6%
$10,000,000 x 0.5583948 = $5,583,948
Actual cash received from the issue $9,263,991

(which is both the issue price and the PV of the liability)

Illustration (cont.)
Hence, the discount is $736,009. We will assume this is a direct

private placement and hence we will not use a trust or application
account.
1. Dr Cash 9,263,991
Cr Debentures 9,263,991

• What does the discount represent?

– The discount represents the difference between the face
value of the debentures (in this case $10,000,000) and the
amount actually received from the issue
• How should we account for it in subsequent periods?

– The discount is not separately shown. The liability is
disclosed at its present value. In accordance with the
requirements of AASB 9 we use the effective interest
method, which means that at the end of the debenture term
the present value of the debentures will equal the face value

Using the effective-interest method, the interest expense will equal
the present value of the liability at the beginning of the period
multiplied by the market rate of interest.
9,263,991 x 6% = 555,839.50
The accounting entries to recognise the payment of interest would
be:
31 December 2020
Dr Interest expense 555,839
Cr Debentures 55,839
Cr Cash 500,000
30 June 2021
Cr Debentures 59,190
Cr Cash 500,000

Use of the effective-interest method—
Worked Example 10.8 (cont.)
Effective
Opening interest Coupon Net
Period liability @ 6% rate liability
0 9,263,991.0
1 9,263,991.0 555,839.5 500,000 9,319,830.5
2 9,319,830.5 559,189.8 500,000 9,379,020.3
3 9,379,020.3 562,741.2 500,000 9,441,761.5
4 9,441,761.5 566,505.7 500,000 9,508,267.2
5 9,508,276.2 570,496.0 500,000 9,578,763.2
6 9,578,763.2 574,725.8 500,000 9,653,489.0
7 9,653,489.0 579,209.3 500,000 9,732,698.3
8 9,732,698.3 583,961.9 500,000 9,816,660.2
9 9,816,660.2 588,999.6 500,000 9,905,659.8
10 9,905,659.8 594,339.6 500,000 10,000,000.0

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 10.9—Debentures issued at a
premium

Worked Example 10.9—Debentures issued at a
premium
The debenture issue is the same as that in the previous example
except we now assume that the market demands 8% per annum
on such debentures.
Present value of interest payments
$500,000 for 10 periods @ 4%
$500,000 x 8.1108925 = $4,055,446
Present value of principal repayment

$10,000,000 in 10 periods @ 4%
$10,000,000 x 0.6755643 = $6,755,643
Actual cash received from the issue $10,811,089

Worked Example 10.9—Solution (cont.)
Hence a premium of $811,089. We will assume this is a direct

private placement and so we will not use a trust or application
account.
Dr Cash 10,811,089
Cr Debentures 10,811,089

Worked Example 10.9—Solution (cont.)
Again, using the effective-interest method, the interest expense will
equal the present value of the liability at the beginning of the period
multiplied by the market rate of interest.
10,811,089 x 4% = 432,444
The accounting entries to recognise the payment of interest would be:
31 December 2020
Dr debentures 67,556
Cr Cash 500,000
30 June 2021
Dr Debentures 70,259
Cr Cash 500,000

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 debtholder’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
Classification of liabilities as
current or non-current
• Current liabilities (AASB 101) are liabilities that satisfy any of
the following criteria:
– 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
– Liabilities in respect of which the entity does not have an
unconditional right to defer settlement for at least 12 months
after the reporting period
• Non-current liabilities (AASB 101) are:
– all liabilities that do not satisfy the criteria for defining
current liabilities

Classification of liabilities as current

or non-current (cont.)
• 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’


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Chapter 10

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Objectives of this lecture

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

• Three components of the liability definition

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Liabilities defined (cont.)

– the amount of the liability must be able to be reliably measured

• Where the entity retains discretion to avoid making any future

• Some professional judgement might be required to determine if

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

 present obligations not yet probable and/or not measurable

(Example: guarantees to cover another organisation’s debts or

• NOT recognised as liabilities in the statement of financial position

• ONLY disclosure as a note in the notes to the financial statements

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

• Therefore if something is disclosed as a provision this should

• Traditionally, a number of ‘provisions’ were included as

– For example, provisions for employee entitlements and

• Now, if amounts are ‘provided’ for future expenditure but there

– they may not be recognised as liabilities

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Liability provisions (cont.)

– For example, penalties for unlawful environmental damage

• Measurement of provisions (AASB 137)

– The best estimate of the expenditure required to settle the

– If materially different from its undiscounted value, the

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

• Provisions must be reviewed at each reporting date (AASB 137)

• Where a change in the carrying amount of a provision is due to

– where discounting is used, the carrying amount of a provision

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Change in the present value of a provision

• Liabilities, including provisions, shall, to the extent they are

• Let us assume that an organisation in 2019 has a liability for

Dr Interest expense 1.88m

Cr Provision for clean-up 1.88m

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

• They ARE present obligations (to a third party) but:

What they are NOT:

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Provisions vs contingent liabilities

• Appendix B to AASB 137 provides a useful decision

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Some implications of reporting liabilities

• How liabilities are measured and disclosed will affect

– For example, debt-to-asset constraints

• It is hypothesised that managers in organisations close to

– increase income (thereby assets and owners’ equity), or

• Whether or not particular accounting methods are adopted

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

• All things being equal, firms typically prefer to disclose

• If securities are defined as ‘debt’:

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Debt–equity debate (cont.)

• AASB 132 Financial Instruments: Presentation

• Refer to Worked Example 10.6—Impact of classifying

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd

Debentures issued at par

• Par (or face) value